Hugh Sinclair is a (self-described) whistleblower who recently published a book coming clean with the microfinance industry. Paul Lagneau-Ymonet and Phil Mader had the privilege to ask him how microfinance went astray and “betrayed” the poor, and why the public and donors are being deceived. His book “Confessions of a Microfinance Heretic: How Microlending Lost its Way and Betrayed the Poor” has been widely noted by international media and his blog follows the day-to-day antics of the microfinance industry.

Hugh, you worked in microfinance for 10 years, so you must have at least for some time believed in this as a tool for reducing poverty. When did you become disillusioned, and why?

I can’t say there was one moment of revelation. The first concerns started on my very first project. I was working in Mexico with a Grameen replica institution, and right from the beginning I noticed many of these people aren’t using the money for a productive use, and many of them aren’t actually very poor at all. But I told myself maybe I’m just in a bad institution.

I worked in Mexico for a couple of years, then I moved to Mozambique. There I discovered an even worse situation. Not only was microfinance not having much impact, but the institution that I was working at was misappropriating the savings of the clients. They were forcing the clients to make a savings deposit, and then they were using that deposit to subsidise their own operating costs, which generally involved paying high salaries to ineffective expat senior managers to fly business class and drive around in fancy 4x4s, which to me didn’t seem like a particularly good use of the client savings. It’s theft – I mean, you can’t just take people’s savings and spend them on your salary.So I thought: wow, this is a terrible institution. But maybe I’ve just been unlucky that I’ve stumbled into a few bad ones. Why don’t I go over to Europe and work at a microfinance fund, and my knowledge about the difference between a good and a bad microfinance institution will be useful to direct their money towards good microfinance.

“The problem is that [microfinance funds] have a weird set of incentives that aren’t aligned with their own investors, and also aren’t aligned with the interests of the poor.”

In Holland, I started working for a new, big microfinance fund called Triple Jump. They had a portfolio ranging from some very good institutions to some very bad ones. And there what I began to realise was, in actual fact the perverse incentives extend right up to the investment players in the sector. The microfinance investment funds tell the investors: “you give us your thousand Dollars, or hundred thousand Dollars, or your million Dollars, and we will lend this on your behalf to the microfinance sector”. That’s the general sort of intermediation that the microfinance funds do. But the problem is that they have a very weird set of incentives that aren’t aligned with their own investors, and also aren’t aligned with the interests of the poor. I began to see this very tangibly at Triple Jump.

So what exactly is the incentive structure faced by microfinance investment funds – whom do they serve primarily?

Who they serve ultimately is themselves. They’re self-interested organisations. What they tell the investors is: “we will invest your money according to what you want”, and that’s supposedly to offer nice loans for pulling people out of poverty. But the problem is these funds usually operate on quite thin margins, earning a management fee of two percent typically; due diligence is quite expensive because it’s not easy to fly to all these weird places; the quality of data is not very good; they don’t pay their staff particularly high salaries, so they don’t necessarily have very competent staff who can really dissect a microfinance institution. And really their incentive is to make a decent return and not have any defaults.

If the funds want no defaults, they either have to actually know what a well-run microfinance institution is, or they have to just lend to the ones which are sufficiently profitable so it doesn’t matter if they’re well-run or not. More profit, less headache, greater return. Plus the other incentive of these microfinance investment funds which is, again, completely bizarre, is that many of them manage multiple funds. So they might have two or three debt funds and they have an equity fund. So what they’ll do is, they’ll use the debt fund, usually from softer sources of money – nice money from charities or philanthropists, governments, international agencies, whatever – and they’ll use that as a sweetener for the microfinance institutions.

“It’s the unwritten rule in microfinance. When a microfinance institution privatises … the people who get the equity are the ones who provided the loan capital, and the senior management.”

So what they say is, “we’ll give you some nice cheap loan capital, here you are: 5 percent, 8 percent, whatever. We’ll take the foreign exchange risk and everything”. At the same time they have an equity fund, and the tacit agreement is: we gave you cheap capital. When you do your IPO, when you become a for-profit institution, we want to be first in line for buying shares in the company. It’s the unwritten rule in microfinance. When a microfinance institution privatises, converts from being an NGO to a for-profit limited company, the people who get the equity are the ones who provided the loan capital, and the senior management.

But given these problems, how come microfinance has become so popular?

I think there was donor fatigue, when people said donating money to Africa just isn’t working, we’ve got to try something new. Something new came along, which appeared to tap into a different kind of psyche based on the entrepreneurial flair which would be innate in every single human being. And that also attracted the attention of the bankers who suddenly saw an opportunity that they could reach an entirely new virgin market of clients, a billion people or so at the bottom of the pyramid. And at the same time, they could make a nice return on entering into previously unsaturated and entirely unregulated markets where they could charge massive interest rates, and profit. It was this combination of various things.

Could this have been any development tool based on self-help and entrepreneurialism, or is there a reason why credit became such a popular device?

Well, one of the things people say is very important is microsavings, the poor need to be able to save, the poor need insurance, and so on. The poor need all sorts of things – but the problem is that only one thing is extremely profitable for microfinance institutions and their investors: credit. I think one of the most critical arguments in favour of any kind of financial services for the poor is the income-smoothing argument, that they’ve got very volatile earnings and this causes big problems in their day to day lives. But if the problem is volatility, then credit is no more applicable to removing the volatility than savings. And yet, there’s been very little focus on savings.

“Only one thing is extremely profitable for microfinance institutions and their investors: credit… There’s been very little focus on savings.”

The problem is if you provide a mechanism for people to deposit their money and then withdraw it when they need it, how can you make profit out of that? Whereas if you can say to them: hey, you’ve got a shortfall – Buy a loan! Take out a loan! – it can create this kind of debt society. You can consume now, why wait? Buy now. And when you finish repaying that loan, we’ll give you another one, and another one, and another one. And if you need to take a loan from another bank, we won’t mind.

“The more debt you have, the better, because that’s all interest payments for us.”

We’ll allow you to get overindebted, as long as it doesn’t get too out of control and we lose our money. Effectively, the more debt you have, the better, because that’s all interest payments for us.

But since microfinance was always intended as a development tool, is this focus on debt the fundamental problem? Or if not, where would you see problems in the principal idea of microfinance?

If we’re looking at microcredit – specifically loans, not savings or insurance – there are many problems. For a start you’ve got the idea that microfinance is used to fund an entrepreneurial activity, that people will buy a productive asset which helps them work their way out of poverty. But where is the evidence of that? If you go to any of the websites, and the marketing materials, and all the little Youtube videos that microfinance institutions and their zealots post, it’s always the women with the goats and the sewing machines. The reality is that a vast amount of microcredit is not used on entrepreneurial activity at all. It’s used on consumption or repaying loans to other institutions.

“A vast amount of microcredit is not used on entrepreneurial activity at all. It’s used on consumption or repaying loans to other institutions.”

Now, it’s very difficult to get hard data because the microfinance institutions don’t want to publish the amount of money that they lend that didn’t end up in a micro-business at all, because they’re extremely embarrassed by it…

…Are they even interested in finding out what the proportion is?

What the percentage of consumption credit is very difficult to know. First, because people have an interest in not publishing the data. Second, because money is fungible. But if you look at what John Hatch said [reported by Steve Beck and Tim Ogden in the Harvard Business Review]: I reckon that the amount of microcredit that is ultimately destined for consumption is 90 percent. I was amazed at that. I wouldn’t have said it was that high, I always reckoned it was somewhere around 75. But without a doubt it’s well over half. To cite a couple of, maybe silly, examples: people were lending on Kiva for people to start up cock-fighting businesses and coca leaf production. And at least those two you could argue are income-generating. But a vast amount of lending is consumer lending and debt repayment. So where is that wealth-creating? Where is that generating economic growth?

And that’s only the consumption lending. You’ve then got the lending used to repay a moneylender or another bank. That is also not particularly productive, it’s just passing the loan around from one institution to another. And the evidence of this is that you’ve got chronic overindebtedness across the entire world. If you look at the Microfinance Banana Skins Report over the last few years, and the report for 2012, the number one risk is overindebtedness.

Look at all the different countries’ microfinance sectors that have collapsed because people got far too much credit. They just recycle this time and time again until eventually the music stops – and you get a collapse. You’ve got Bosnia, Pakistan, Morocco, Bolivia, and then the one which I saw most closely was Nicaragua, where there was frankly just a ridiculous situation of overindebtedness.

So what about the rest, the actual microbusiness loans?

Okay, let’s just look at that proportion of the clients who do in fact invest in a business, let’s say it’s whatever, 20 percent: what are they actually doing with the money? They’re not investing in designing some new product or opening up some new market. They’re buying inventory for their little stall in some marketplace, which is sitting on a shelf getting dusty in a competitive market with zero barriers to entry, homogeneous goods with a thousand people all selling the same stuff.

So what happens is: the laws of economics kick in, there’s a glut of supply, the price falls, the margins fall, and you arrive at a new equilibrium at which all those products are just slightly less profitable for everyone.And, even if you say that some sort of increase in inventory is a good idea, where is the demand? If there are no new customers to come in and buy this surplus, then one of the only solutions is that the microfinance institutions can also lend on the demand side. They lend to the consumers to consume more, artificially boosting supply and demand, and saddling both sides of the market with interest. And that interest is a net extraction of wealth.

What we are actually doing is spending billions of dollars to getting people selling apples on street corners. Where is the economic impact of that? We are even getting children to sell cigarettes and sweets and chewing-gums, wandering around discos at night. If we then say “we should lend money to the smokers in order to make them buy the cigarettes from the child”, there is no economic growth in that. The fundamental micro-businesses are, for the most part, trinket vendors. They are labour-intensive… and one aspect which the microfinance has been very keen to ignore is: how are these people going to grow their businesses? Where is the only available source of free labour that these people can get? Children.

“The microfinance sector says ‘we are not going to have the issue of child-labour put on the table’. “

The microfinance sector refuses even very explicitly to address the topic: “we are not going to have the issue of child-labour put on the table”. The SMART Campaign, I can send you the email, very explicitly said “we are not adding child-protection clauses to our client-protection principles”. And the argument is: we do not lend to children, we lend to their parents. Those are our clients. It is the client-protection principle and it extends to the client only. What they do to their children has nothing to do with us.

So in the microfinance industry, we are simply speaking of players who are playing a game they can get away with. What seems to be missing in this story is, first, regulatory oversight, but second also any sort of critical inquiry by the investors: those who are providing the capital.

To look at the structure of the industry: the problem is that the microfinance funds essentially act as gatekeepers. They know that for the philanthropists and the Kiva users who invest their 25 Dollars there is no way to get to the micro-entrepreneurs directly. The philanthropists and other providers of capital have no way of verifying the claims made by the funds; the regulators in Europe or America have no way of actually finding out what’s going on on the ground; the regulators on the ground usually either don’t exist or are utterly incompetent and they don’t really care, so they’re not going to do much good; and the local microfinance management have every incentive to play ball with the investment funds, because that’s where they get the money from. If they can grow their businesses into large profitable microfinance banks and then eventually privatise them, they will get paid handsomely. So all the interests are aligned against the interests of the poor and there is no scrutiny at any stage.

“So all the interests are aligned against the interests of the poor and there is no scrutiny at any stage.”

Now there are a few exceptions, countries such as Ecuador where you have a really tight regulator who’s properly regulating the microfinance sector. But what you see as a result is that the investors are no longer so impressed. They don’t like investing in Ecuador. Why? They’ve put an interest rate cap on. “What do you mean we can’t charge more than 30 percent? How are we going to make any profit?” Well, everyone is making profit, even with the Ecuadorian government putting on an interest cap at 30.5 percent the sector didn’t collapse. But if you’re sitting in Switzerland and you can invest in either Ecuador or Mexico, and in Ecuador you know that the maximum gross margin your investment can ever make is 30.5 percent, and that’s if you get 100 percent repayment, versus in Mexico where there are no rules and you have Compartamos charging 195 percent: which one are you going to invest it in?

But aren’t we always told by actors like the World Bank that, in time, competition will drive the bad players out of the market and make sure everyone charges the lowest possible interest and offers the maximum social return?

Yes, that’s what we are told. But there’s not much evidence of that happening so far. The microfinance promoters basically play the pure free-market argument. They say there is no need for regulation. Just competition itself will, somehow, make the world become a better place. Now, they often cite the example of Bolivia, but look what happened: over the last ten years, the interest rates went down from fifty percent to twenty percent. It is true that it did happen there and happened in other countries. But one of the main reasons for why that happened was thanks to regulation. In countries like Bolivia, the regulators came in and said; no, there are no more fifty-percent interest rates. You’ve gotta have those down right now.

“They say there is no need for regulation… The microfinance promoters basically play the pure free-market argument.”

The other major problem with the competition argument is that it assumes microfinance institutions don’t form tacit cartels. You’re talking about countries that don’t have anti-competition, cartel laws; but they have very well defined associations of microfinance. All the microfinance institutions form nice associations and they are supposed share knowledge, best practices and other sorts of stuff. What is the rational thing for these microfinance institutions to do?

Nicaragua was the classic case: you had a country which was absolutely saturated with microfinance and interest rates that didn’t go down at all. In Mexico, you had interest rates at about 50 percent at the beginning of the century, when I was working there. You had this influx of competition and what happened? The interest rates were going up, and not a just a little bit, they were going up from fifty or sixty percent a year to approaching two hundred percent a year in certain cases. So the competition argument is ridiculous.

Would you consider that interest ceilings and anti-competition laws, at the local level, offer sufficient regulations?

Interest caps, if they are sensibly applied, I think are a very useful tool. Of course they can be used badly by the regulators: if they put the cap too low, they could destroy part of the sector. And also, if they put it too low, they can encourage the sector to only work in the most profitable areas, i.e. cities. But here is the million-dollar question for regulation: what is easier? You have microfinance in 80-100 countries around the world. You can go in each of these countries and regulate each one individually, with all their political, social, economic complexity. It is very, very difficult to do that in practice. And then, how you are going to enforce the legislation?

Why not regulate the microfinance funds in Europe and in the US? If you just had rules in the States, Holland, Germany and Switzerland, just those four countries, you are covering circa the vast majority of all private capital that goes into the microfinance sector. And you say to the microfinance funds “you are responsible”. If you do an investment in an institution which is found to be illegal, or is breaking the law, or is allowing child labour or is forcing clients into suicide, you hold the microfinance fund liable for that, and you could create an easy and cheap way to get regulation in the entire sector.

“If you make the same regulation for the microfinance sector as you make for the rest of the [financial] sector, there will be a huge improvement.”

If you look at Deutsche Bank in the US, it is [among other regulators] regulated by the Stock Exchange Commission and it is not allowed to invest in people-trafficking, drug-smuggling, animal cruelty. And the bank won’t, because it fears the regulation in the US. Deutsche Bank can’t say “we were lending money to coca producers in Peru, and that is legal in Peru”. Why is it that Deutsche Bank is not allowed to invest in certain activities because there are illegal if it is a regulated institution, but if it is operating a microfinance fund those activities are exempt from regulation? It’s obscene, ridiculous. If you make the same regulation for the microfinance sector as you make for the rest of the [financial] sector, there will be a huge improvement.

We’ve been talking a lot about regulation. But you would assume that many people in the microfinance sector are pursuing some sort of social aim. Are they all blind to the problems you have documented? How can they live with this discrepancy?

The microfinance funds are the most vocal people against regulation. But, with regard to social aims, what the microfinance community has done quite cleverly, is to come up with self-regulation. Actual regulation is a bit awkward for them, so they have come up with this compromise: “we believe in the fair treatment of the poor and we’re going to set up these self-regulatory bodies that we will fund. And we will show the world how wonderful microfinance is.” The problem with the self-regulatory institutions – the classic thing being the SMART campaign – is that anyone can sign up to it: anyone, it does not matter. You could shoot your clients who don’t repay, you could rape and pillage people, whatever you want – there are absolutely no criteria for joining the SMART campaign.

All you need to become an endorser of the SMART campaign and put it on your website is an email address and a name. So you have some of the main offenders in the world, some of the organisations who have been directly implicated in some of the worst offenses, such as the suicides in India, cases of forced prostitution, some of the people who are charging the absolute highest exploitive interest rates, lying about their interest rates, illegally capturing savings from the public without bank licences, as members of the SMART campaign. It’s endorsement without enforcement. It’s a deliberate marketing campaign to give the impression to the outside world “look, everything is fine”.

Do you consider it likely that thanks either to your book or any other developments going on, microfinance will change for the better?

I sincerely hope so. I don’t have any more tools. I have tried working with people directly and pointing problems out. I tried leaking things to the press and I got articles published in a number of newspapers. I got an article published on the front page of the New York Times. That created a small ripple and then it just died off. I’ve written a book now. I don’t know what else I can do.

If people ignore this, I just give up. Because the evidence that the general public including governments in the Western countries has been deceived, that they have been taken for a ride, is overwhelming. The academic evidence that microfinance is not having any positive impact is overwhelming. Common sense, just thinking through it logically – helping these people in those situations, is overwhelmingly against microfinance.

“The evidence that the public … has been deceived, that they have been taken for a ride, is overwhelming. Common sense… is overwhelmingly against microfinance… But you have spin and marketing campaigns pulling in another direction.”

And yet you have all this knowledge, proof and evidence, common sense and theory that are all pointing in one direction; but you have spin and marketing campaigns pulling in another direction. You have this classic tension. Who’s going to win? You have powerful vested interests, people stretching to the very top in these countries, who have personal interests in microfinance perpetuating year after year. They have done 200 million people so far and they want to do the next billion. And they will make a lot of money if they can do that.

Hugh, thank you for this fascinating interview.