Microfinance investment vehicles control huge capital and by virtue of that they are often able to channelize cross-border flows significantly. These and related institutions should come under proper regulation, reporting and disclosure requirements

I recently read a book, “Confessions of a Microfinance Heretic: How Microlending Lost Its Way And Betrayed the Poor” by Hugh Sinclair, (2012) published by Berrett-Koehler Publishers, Inc.

The book was a very interesting read but the claims made by the author jolted me. Among several other things, the author Sinclair claims that reputed institutions like Grameen Foundation, microfinance investment vehicles (MIVs) such as Triple Jump (TJ) which manages several funds (on behalf of ASN Novib, Calvert Foundation, etc) and big global banks like Standard Chartered, Deutsche and Citi—invested in LAPO, a Nigerian MFI—despite knowing that LAPO was: a) involved in (illegal) intermediation of client savings; and b) charging phenomenally high rate of interests (over 100%).
 

While I will be reviewing the book separately in a later column, here I try and look at some of the claims made in the book:

a)    Illegal Intermediation of Savings:

"Some rating reports of LAPO published by a company called MicroRate had specifically discussed some of these points, including the illegal lending of client savings. MicroRate was surprisingly accurate in its analysis of LAPO, stretching back to 2006, and yet investors had somehow managed to overlook the criticisms raised in their reports." (Page No.93 of Sinclair's book)

"What I hadn't realized at this point was the complicity of the microfinance funds in such practices How much did these guys know about the truth of microfinance? Were they actually deceiving their own investors, or were they simply naïve? Or were they actually working with these extortionate MFIs in the hope that they might reap the huge rewards of a stock market flotation, as the shareholders of Compartamos had?" (Page No.104 of the book)

"By July 2007 most of the truth about LAPO was known by Triple Jump and Grameen Foundation. We hadn't actually discovered much 'new' information that hadn't been included in rating reports written years prior to our trips. We had merely added detail and supporting evidence to such discoveries. Somehow these factors had managed to evade the attention of the funds. Even when information that directly challenged the assumption of massive poverty reduction was known, this did not necessarily dissuade funds from investing in the MFIs. And if the funds were perceived as tolerating such practices, what incentive was there to prevent them?" (Page No.104 of the book)

"Of course, Calvert had no idea it had been deceived. Bruno Molijn, at Oxfam Novib, had remained suspiciously quiet during this entire process, although he had seen the entire situation emerge. What about the other investors in LAPO? Deutsche Bank might find this result interesting, as could Citibank and Standard Chartered. Muhammad Yunus was lecturing the world about the evils of extortionate interest rates, and yet Grameen Foundation was one of the largest investors and guarantors of LAPO. How could they square interest rates of 126% at LAPO with his usual speeches? " (Page No.133 of the book)

"MicroRate went on to discuss the practice of capturing savings: "Client savings intermediation without a license… Approximately one-third of the funding is provided by client deposits even though as an NGO, LAPO is not licensed to mobilize savings…. In MicroRate's opinion, this policy bears a serious risk…. LAPO is neither authorized nor adequately equipped to mobilize savings from the public… LAPO's present policy of using savings deposits to fund its operations-besides being illegal - exposes its clients to risks of which they are unaware… intermediating savings on a large scale without the proper authorization must be considered unacceptable" (emphasis added). A fund manager who failed to get the hint here should possibly not be managing a fund." (Page No.139 of the book)
 
"A number of lesser critiques appear in the reports, but there was little doubt that two consistent reports written by a reputable ratings agency had highlighted extremely dangerous, inappropriate behaviour. And yet such factors, written clearly in publicly available documents read by most microfinance funds, had not deterred the investors, who were also listed in the report.  These now included Triple Jump and ASN-Novib, Deutsche Bank, Citibank, Calvert Foundation (invested via Triple Jump), Kiva, and Grameen Foundation USA, somewhat in contradiction to Muhammad Yunus' usual stance on high interest rates." (Page No.139 of the book)
 
"For any of these funds to deny knowledge of LAPO's true nature was a double-edged sword-had their analysis not extended to reading a rating report? This would suggest unimpressive due diligence, one of the few functions of a passive fund manager. But to admit knowledge of these issues was akin to condoning it. "We knew about these issues and invested regardless" is an even more alarming response. The best course of action was to say nothing, which is precisely what the funds collectively did. If asked, drab comments such as "we are aware of the issues and are working with LAPO to resolve them blah blah" would suffice."  (Page No.139 of the book)


b)    Loan Product, Interest Rates and Savings:

"The next problem was that LAPO claimed to be charging clients 3% interest per month in interest for eight-month loans, or 24%. The actual number of weeks was 31-which is not eight months, but 7.15 months. The interest charged was 24% regardless of the fact that the client did not receive the loan for eight months. Thus the rate was not 3% per month, but 3.35% per actual month, or 40.26% per year. Clients were simply paying more interest on their loans than they should, while receiving less interest than they should on their savings. If 31 weeks was eight months, LAPO was implying that the year was only 46.5 weeks long, which appeared to be at odds with accepted wisdom… In addition to this, endless fees and commissions were charged to clients, and they were forced to make a 20% cash deposit in order to obtain a loan: more forced savings." (Page No.92 of the book)

"Most institutions using this practice keep the forced savings in a separate account that the bank cannot touch-this money does not belong to the bank but to the clients. Not at LAPO. LAPO would take these savings and promptly lend them back to clients, earning a hefty interest rate in the process and paying the clients peanuts on their savings, not even covering Nigerian inflation. Thus the real value of the clients' savings, even with the token interest payment, would be eroded through time-the poor would get ever so slightly poorer." (Page No.92 of the book)

"So, a client requesting a $100 loan would have to deposit $20, which would then be topped up by an additional $80 and lent to the client, with interest calculated on the basis of the original $100… With a regular mortgage, some form of deposit may be asked, but with one critical difference to the LAPO offering. If a house costs $100,000 and the bank insists on a deposit of $20,000, the bank in effect offers a mortgage of $80,000, and the client pays interest on only $80,000. At LAPO the client would pay interest on the full $100,000". (Page No.92 of the book)

"A final blow to the poor clients was the calculation of interest. Anyone with a mortgage is familiar with how interest rates are calculated-interest is paid on the amount outstanding. If one repays a portion of the mortgage, the interest paid on the mortgage goes down accordingly. Not at LAPO. LAPO uses an interest rate calculation method that is fortunately banned in many countries, called "flat interest rates."1 The ingenious benefit of charging clients flat interest is that the interest rate is calculated on the original loan amount even while the loan is being repaid. LAPO loans are repaid in 31 equal instalments over 31 weeks. Thus, after 15 weeks approximately half the loan has been repaid, but the interest is still calculated at 3% per month (which isn't actually a month) of the original loan amount (which they never actually received in the first place due to the forced savings and other fees and commissions deducted from the disbursed amount). In short, the clients were getting entirely fleeced in all ways possible." (Page No.92and 93 of the book)

"One might wonder why the investors in such MFIs aren't a little concerned about the interest rates charged to the poor. The problem is, to the extent that high interest rates reduce the possible impact on poverty, they boost the profitability of the MFI, and thus the MFI's ability to repay loans to the microfinance funds." (Page No.102 of the book)

c)    Due Diligence by MIVs and Global Institutions:

"Due diligence is the term applied to the exploratory investigations a fund sometimes does when researching a new potential MFI to lend to. Much of it is done from air-conditioned offices in Europe and the US, involving reading a rating report if one is available, perhaps requesting one if not, sitting on the Internet for a few hours, making a few phone calls, looking at the various sources of publicly available information, and speaking off the record to other funds that may have invested in the same MFI. The funds will sometimes physically visit the MFI, although amazingly this is not true in all cases. Funds are naturally hesitant to admit the proportion of their investments that they have never actually visited. They may well be taking money from pensioners in Europe and invest them in some small MFI in an unfamiliar African nation without ever actually visiting the MFI." (Page No.75 of the book)

d)    Savings and IT systems:

"Our job was to fix the IT system, a scope thankfully limited to only one of the gaping holes in the institution, and toward this goal we began the march. The first issue to consider was why the database contained so much nonsense data. The problems seemed to revolve around two issues, both related to interest rates. M2 was apparently calculating the interest on client savings accounts incorrectly. The communication between LAPO and Weng suggested a grave error in M2 that no other M2 client had detected. LAPO paid clients 6% per year on their savings balances, which is 0.5% per month. However, when LAPO configured M2 accordingly, a client with $100 in savings would end up with marginally more than $106 at the end of the year. This was wrong, according to LAPO." (Page No.90 and 91 of the book)

"After one month, a client with a balance of $100 would earn $0.50 in interest. The following month the client would earn slightly more, since the interest was then calculated on a balance of $100.50 rather than the initial $100. The effect of this over an entire year would accumulate, so that the final balance of the savings account would not be $106, but $106.17. This basic law of finance, called compounding, had evaded the entire institution. "(Page No.91 of the book)

"LAPO's solution to this critical 'flaw' in M2, apparently unique to it was to ask Grameen Foundation USA to help. Weng was well versed in the basic laws of finance and accounting and had been unable to find any problem in M2-because there was no problem. Grameen Foundation sent a consultant over to Nigeria to fix the problem, which he had apparently done." (Page No.91 of the book)

"Jose Manuel discovered large batches of transactions executed in precisely the same second that 'corrected' the savings balances. All such transactions had a mysterious user ID: transactionkiller. Users could select a username at will, but we thought this name was unusual. We asked the IT department about this unusual user. "Ah, that is special tool that Grameen Foundation made for us. It makes the problem go away." Grameen Foundation's tool made the problem go away by siphoning money that clients were rightfully owed from their savings accounts. The $106.17 in savings of these poor clients was reduced manually back to $106. "(Page No.91 of the book)

"All the savings balances were false. Every single one. This tool was designed by Grameen Foundation USA, not some irresponsible local IT geek; LAPO management was aware of its use; the auditors had approved the accounts; and some of the largest microfinance funds on earth were investing in this institution. The tool had its own button on each desktop to automate the process. "(Page No.91 and 92 of the book)

Finding it hard to believe these enormous claims, I asked Sinclair for evidence regarding the claims made in his book and he pointed me to some documents in the public domain (and at the book website - www.microfinancetransparency.com) as being relevant to the LAPO case. A couple of documents relating to Triple Jump (TJ) he claimed that he did not possess on hand but stated that he had seen them at work (as described in the book).

In my opinion, after having seen the various documents, I feel that it may be difficult for Sinclair to prove some of his claims with regard to intentions and related issues. But I think there are a couple of key issues here that are worthy of detailed attention: a) the aspect of whether (or not) LAPO had indulged in illegal savings intermediation; and b) the issue of whether (or not) LAPO's interest rates were as exorbitantly high as claimed by Sinclair. And I look at these issues in a question and answer format and try to provide evidence from the public domain!

Read On…

Question # 1: Who were the investors in LAPO?

While transparent information is not available to date, a look at the MicroRate rating report (2007) suggests the following:

Question # 2: Did LAPO collect Savings?

I looked at my favourite data source, the mix market and compiled the following data. Clearly as the data reveals, LAPO has been collecting savings for several years now. It is also interesting to note that the number of depositors has always exceeded number of active borrowers since 2005, implying that LAPO also perhaps collected voluntary savings! In 2008 alone, LAPO was in fact servicing 45,000 more depositors than active borrowers.
Question # 3: Was LAPO legally allowed to intermediate client savings (back then in the years - 2006, 2007 etc- preceding its transformation)?

MicroRate's 2007 rating report (Lift Above Poverty Organization (LAPO) Rating Report by MicroRate, December 2007) clearly mentions the following:  

"Client savings intermediation without a license and without an appropriate structure" as a weakness (Page No. 1).

"Borrowings are well diversified among a large number of mainly foreign lenders. Approximately one-third of funding is provided by client deposits even though as an NGO, LAPO is not licensed to mobilize savings." (Page No. 5)

"With a cost of only 4%-5%, savings deposits are a much cheaper source of funding than commercial credits. Recognizing this, LAPO has strongly pushed savings mobilization. In MicroRate's opinion, this policy bears a serious risk since as a NGO, LAPO is neither authorized nor adequately equipped to mobilize savings from the public." (Page No. 5)

"LAPO's present policy using savings deposits to fund its operations-besides being illegal-exposes its clients to risks of which they are unaware." (Page No.6)


Question # 4: Was LAPO's loan product legal back then (in the years 2006, 2007, etc preceding its transformation)?

As LAPO's collection and intermediation of savings was illegal as mentioned above, LAPO's loan product is also (perhaps) illegal as collection of savings was an integral part of this loan product

Question # 5: Did LAPO charge exorbitantly high rates of interest?

I have always been a strong advocate of de-regulated interest rates and have often championed this. However, I find it hard to accept that clients must borrow at rates in excess of 75% to 100%, whatever be the circumstances. Now for the evidence:

a)    The MicroRate rating report of 2005 notes that LAPO's loan products in 2005 were

b)    Likewise, the MicroRate Rating report of 2007 notes the following with LAPO's loan products in 2007
c)     And the Planet Finance rating report of 2009 notes that,

"Since the end of October 2009, all clients pay a 2.5% monthly flat interest rate (from 3% before), disbursement and administration fees, and a 2% risk premium (covering clients in case of fire or death).  Earlier in 2009 before that change of pricing, LAPO increased the amount of cash collateral requested as compulsory savings prior to loan disbursement, from 10% to 20% of the loan amount (upfront) and from 50 to 100 NGN at each instalment. Compulsory savings earn interest at a rate of 4% per annum (from 6% before). The decrease in interest rates coupled with the increase in the level of cash collateral, resulted in an increase of the average Effective Interest Rate (EIR) for the clients to 125.9% from 114.3% before. "  (Lift Above Poverty Organization (LAPO) Rating Report by Planet Rating, December 2009, Page No.6)

d)       The icing on the cake is however what Microfinance Transparency is said to have noted.

"LAPO had its pricing certified by Microfinance Transparency as of December 2010 for its Regular Loan. The average price for a first-time loan with insurance was estimated at 80%, expressed as a nominal APR. Since then, the average APR for Regular Loan decreased to around 76%. However, Microfinance Transparency also noted that as the client remains with LAPO, the APR can reach between 99% and 144% by the third year (depending on the loan amount and increase at each cycle) due to the cost of accumulating weekly savings that cannot be withdrawn." (Lift Above Poverty Organization (LAPO) Rating Report by Planet Rating, December 2011, Page No.7)

Ladies and Gentlemen, I am not sure that any MFI which charges an effective interest rate (EIR) of around 144% is in anyway doing something even remotely connected to poverty alleviation.

To summarise, as a practitioner of micro-finance for over two decades, after reading Hugh's Sinclair's book, I am very concerned about several issues:

1.    First and foremost, how did the then funders (given in Table 1 earlier and other subsequent investors (Responsibility, Blue Orchid, etc)-get involved with LAPO despite its carrying on illegal savings intermediation activity as per the rating reports available in the public domain?

2.    Second, was there not any due diligence on the part of the various funders and investors and if so, did not this due diligence uncover these crucial facts (also available in the public domain)?

3.    If the due diligence brought out the key facts (also available in the public domain), then, why on earth did these well known and reputed institutions invest in LAPO, despite knowing that something illegal was going on?

4.    If the due diligence did not uncover the true facts, then, what does it say about the quality of due diligence at these well known institutions? Also, if due diligence had indeed been of poor quality, did subsequent internal audit processes at these institutions uncover the fact that due diligence was not up to the mark? It would be very interesting to understand this!

This is especially critical because many of these institutions are dealing with public money and also intermediating deposits. Therefore, they carry a huge responsibility to ensure that the funds entrusted with them are invested in a safe and sound manner. Forget LAPO and hopefully it is just one case but what is the guarantee that there are no more LAPOs around? That needs to be answered fair and square.

5.    Given that they are very key players in the financial inclusion domain, how are MIVs, global banks and related institutions regulated with regard to their micro-finance activity and investments? They control huge amounts of capital and by virtue of that they are often able to channelize cross-border flows significantly. We saw what happened in India after the Krishna crisis of 2006 when huge equity flows and external commercial borrowings coupled with local bank funding created a perfect storm (as Mix Market has noted) to trigger the 2010 Andhra Pradesh microfinance crisis. Given that, should not MIVs and related institutions come under proper regulation with relevant reporting and disclosure requirements? This is especially critical because they all intermediate and invest public money- collected as deposits from public, donations from individuals etc and/or contributions from national governments.

All of the above are very serious issues and I would expect every institution involved in the LAPO case to make public their answers to these questions. While I tried my best to contact many of these investors, some of them replied and others did not. But even those who replied often skirted the real issues... I really hope that the global microfinance industry wakes up to the reality and sets its house in order… And for GOD's sake, let not shoot the messenger. Let us follow-up Sinclair's huge contribution and make sure that cleansing actually happens on the ground!

(Ramesh Arunachalam has over two decades of strong grass-roots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural and urban development and urban poverty alleviation across Asia, Africa, North America and Europe. He has worked with national and state governments and multilateral agencies. His book-"Indian Microfinance, The Way Forward"-is the first authentic compendium on the history of microfinance in India and its possible future.)

[i] Investors are listed in the ratings, which are publicly available. However, not all investments are publicly available, so it is hard to estimate who is, and was, the largest investor. Supporting evidence on the book website.

[ii] MicroRate 2007 LAPO rating, p. 6, also subsequent “unacceptable” reference.

[iii] MicroRate 2007 LAPO rating, p. 5.

[iv] The 2% are distributed between LAPO (1%) and MISS (1%), an affiliated company (refer to the section on LAPO group) that provides this service to LAPO clients.

[v] The EIR without the cost of cash collateral decreased to 73.5% from 85.1% before. The EIR without the risk premium fee and the cost of cash collateral decreased to 65.7% from 78.8% before.