Microfinance Control Fraud in Latin America

Abstract

Over the past three decades, the global microfinance industry has witnessed phenomenal growth in terms of the numbers of borrowers and the total gross loan portfolio outstanding. An application of the criminologists' perspective and Black's theory of control fraud to the global microfinance industry reveals a high degree of overlap between the common characteristics of control frauds and the characteristics of the microfinance industry and suggests that the sector provides a criminogenic environment suitable to Ponzi-type dynamics, including an imperative of growth, misrepresentation of financial and operating performance, a reputation for integrity and innovativeness, concentration in unregulated markets and areas most conducive to accounting fraud, non-transparency and secrecy, dubious accounting methods, lobbying in favor of deregulation, attempts to suborn controls such as accountants, lawyers, regulators, and rating agencies, executive use of the company for personal gain, excessive risk taking at the expense of investors' capital, warnings raised but ignored, and, finally, inevitable collapse. Regulatory interventions are needed to prevent predatory lending and over-indebtedness of poor microfinance borrowers in Latin America and elsewhere. Such regulation, while necessary to protect the poor, is not well liked by the investment community as it places microfinance institutions under local scrutiny, reduces the profitability of the sector, and limits opportunities for control fraud.

Keywords::

• microfinance
• control fraud
• Ponzi
• criminology
• regulation

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ This paper uses material from Will Butcher's undergraduate thesis, which is based in part on original research undertaken in Ecuador.

² On the contrary, poverty has been increasing fastest in precisely those locations where microfinance was to be found in most abundance. Notably this was the case in Peru and Bolivia, where the microfinance sector was well developed by the mid-2000s and yet appears to have had little impact on the rising level of poverty (Helwege & Birch, 2007, pp. 17–21). In Mexico, a dramatic increase in the supply of microfinance since the early 1990s has been paralleled by a decline in the living standards found in Mexico's poorest communities (Cypher & Delgado-Wise, 2010).

³ For example, the CEO of the Bolivian MFI PRODEM, Eduardo Bazoberry, and his senior employees gradually acquired the shares of PRODEM over time, and in 2007 they sold the entire institution to a Venezuelan bank (Katz, 2007). Although once mere employees of PRODEM, which was capitalized with international donor funds, the sale turned them into millionaires. The management team at PRODEM was subject to considerable criticism by others in the microfinance industry at the time, on account of turning a community-owned and financed institution into their own privately owned institution and then ditching it for personal profit. However, nothing whatsoever was done to preclude similar events happening in future.

⁴ Among the most destructive control frauds are Ponzi schemes, a type of control fraud in which the fraudulent institution must continuously bring in new money in order to pay off old investors.

⁵ This long-running problem encouraged microcredit advocate Chuck Waterfield to set up an NGO—microfinance Transparency—dedicated to publishing the real interest rates applied on microcredit in developing countries. Including fees, administration charges, and other additions that inflate the basic interest rate, Waterfield found that effective interest rates across the board are typically very much higher in the microfinance industry than most MFIs are willing to admit. However, many, if not most, MFIs refused to engage with microfinance Transparency precisely in order not to reveal the very high real interest rates they routinely charged to their poor clients. Indeed, thanks to very little cooperation from the microfinance industry in providing data upon which real interest rates could be calculated, in March 2015 microfinance Transparency announced that it had no other option but to close down (Waterfield, 2015).

⁶ A recent example would be that of the once highly regarded MYC4 based in Denmark, which was forced to close down its investment arm in March in 2015 on account of a series of frauds on the part of its partner MFIs based in Africa (MYC4, 2015).

⁷ Excess investment in the microfinance sector, particularly by international investors, creates liquidity that promotes the unsustainable growth of MFIs. For an insider's account of how non-transparency and inadequate due diligence on the part of MIVs leads to a race to the bottom in which the most ethical MFIs are pushed out of the market for funding by the more profitable sharks, see Sinclair (2012).

⁸ In Bangladesh, for example, the Grameen Bank was for a long time able to hide its deteriorating portfolio (Roodman, 2012).

⁹ The SMART Campaign is run by the leading microfinance investor and advocacy body, Acción, which is also one of the principal shareholders in Banco Compartamos. Acción quite unproblematically awarded the SMART Campaign's ‘Certification of good practice’ to Banco Compartamos (Sinclair, 2014).

¹⁰ In South Africa, severe damage to the reputation of the financial system as a result of the collapse in 2014 of the largest microcredit bank—African Bank—was averted thanks to a $1.6 billion bail-out plan financed by the South African government. See Bateman, this volume.

¹¹ An estimated 40% of poor women in the bottom income quintile in the country are currently clients of MFIs (Rozas, 2014a).

¹² The MIX Market actually gives a figure of 6 million borrowers but this overestimates the total number of borrowers because of multiple borrowing. Adjusting for the multiple borrowing rates, Rozas (2014a) estimates that this implies 2.2 million unique borrowers in Mexico. However, the MIX dataset doesn't include several large MFIs, such as Banco Azteca, and even more smaller ones, so the 2.2 million figure is probably too low.

¹³ See ‘Online Extra: Yunus Blasts Compartamos’ Bloomberg Business, December 12th 2007. http://www.bloomberg.com/bw/stories/2007-12-12/online-extra-yunus-blasts-compartamos (last accessed on May 3rd, 2015).

¹⁴ The ‘two Carloses’ argue that Compartamos will help more poor people by accessing the boundless pool of investor capital rather than the limited pool of donor money. The Co-CEOs also deployed the ‘industry-building’ argument, claiming that Compartamos's success had prompted a number of institutions, including traditional banks and consumer lenders, to start offering financial products to the poor, therefore making Compartamos not only an MFI but also ‘the builder of an industry.’

¹⁵ Three of the four founding members of Compartamos AC, who together held only 6.79% of Compartamos the sofol, continued to have a role on the board of the nonprofit, which was the largest equity holder in the sofol and controlled 39.2% of the votes, giving these three insiders control over the company far in excess of their ownership proportion (Bateman, 2010, pp. 148–149).

¹⁶ Banco Compartamos's lessons were not lost on India's Vikram Akula, for example, who founded his own MFI—SKS microfinance—that went on to become another definitive example of profiteering in microfinance. Akula founded SKS in 1997 as a nonprofit, converted it to a for-profit in 2005, and then sold a part of his shares in SKS in a private sale for $13 million not long after he executed a successful IPO in 2010. Soon after, a microfinance debt crisis in the Indian state of Andhra Pradesh—blamed in large part on SKS's predatory lending and aggressive debt collection practices—led to massive losses for SKS and the share price plummeted by 90%. Akula was later removed from his position as CEO. In effect, Akula brilliantly executed the model of microfinance control fraud that Compartamos had pioneered (Bateman, 2012).

¹⁷ Mexico has one of the lowest microfinance penetration rates in Latin America, at 0.5% of GDP. The fact that the microfinance industry is even measured in terms of GDP is in itself a telling fact about the scale of the sector.

¹⁸ The study reports that, while some borrowers admit that they ‘were tempted to live beyond their means,’ most of the purchases financed by the loans are relatively simple items that could be considered basic necessities, ‘such as school uniforms’ (Ericksen et al., 2014).

¹⁹ According to MIX Market as of 20 October 2014, the MIX Market database only includes those institutions choosing to self-report information to the network. The sum of total industry assets in 2000 includes 14 MFIs, and the figure for 2013 combines total assets for 47 MFIs. Compared to the estimated 300 MFIs in Ecuador (Albarracín, 2014), MIX Market clearly does not include all MFIs in the country; however, the institutions that report to MIX tend to be among the largest in the country, making country-wide totals representative of the actual sum, even though the MIX total will generally be less than the actual number.

²⁰ It is precisely lax regulation in countries such as Mexico and Peru that attracts floods of investor money.

²¹ The new monetary code in Ecuador, passed in 2014, is a set of laws that puts more pressure on the banking sector in Ecuador and gives more control and authority to exercise supervision over banks to the government. The new monetary code allows the government to restrict the profitability of the banking sector—which is seen as benefiting only rich investors—while creating new incentives and support for financial institutions in the popular social sector. The banking sector in Ecuador has historically been the most profitable sector in Ecuador, and is not viewed as having created wealth for the country but for having concentrated wealth in the hands of a very small minority and sending much of this wealth out of the country. Thus, the government seeks greater control over the banks, in part to promote improved equality of income and wealth in the country.

²² Other important elements of microfinance sector regulation in Ecuador include obligatory credit bureau reporting, pricing transparency, and deposit protection.

²³ The SBS has instituted a national price formula, the Tasa Efectiva Anual (TEA), and all public financial institutions are required by law to maintain transparency about the interest rates and fees they charge. The maximum TEA interest rate schedule as of April 2015 is as follows: 30.5% for loan amounts up to $3,000, 27.5% for loans of $3,001 to $10,000, and 25.5% for loans $10,001 to $20,000 (Banco Central del Ecuador, 2015). The interest rate cap dictated by the government is a maximum effective rate MFIs can charge, which includes interest as well as any fees for the loan, discounts on the loan, forced savings, and additional services included with the loan, such as insurance products like life insurance and loan-forgiveness insurance (Ríos, 2014).

²⁴ According to public data from the MIX Market, as of 2013, the average ROA for reporting MFIs in Ecuador was 1.18% and average ROE was 8.42% (last accessed on April 24th, 2015).

²⁵ One concern that deserves attention is that below-market pricing created by the imposition of interest rate caps will invite bribes to MFI employees who make loan decisions and invite borrowers to on-lend the funds at higher interest rates, often to the institution's intended target market. In this way, artificially low rates enforced through interest rate caps can encourage informal moneylending at illegal rates of interest by providing cheap funds to moneylenders. This practice, as well as that of bribery of loan officers, can be prevented through strict enforcement of usury laws by the government along with the use of strong information systems by MFIs, adequate internal and external auditing functions, standardized loan products, employee training, strong organizational culture and mission, adequate employee salary, reduced employee turnover, and actively engaged management (Ledgerwood, 1999, p. 259). Many of these positive characteristics are evident among a number of the MFIs currently operating in Ecuador.

²⁶ With the new financial services law issued in 2013, Bolivia is moving from liberalization of the financial sector to greater state oversight, with the adjustments meant to control corruption, restrain excessive banking sector profitability, and increase access to financial services for the poorest. The primary features of Bolivia's new regulatory regime include interest rate caps for credit, interest rate floors for deposits, quotas for MFI interventions in certain social sectors, and financial and legal disincentives for international funders of microfinance in the country. These goals and measures largely mirror those of Ecuador's new financial system regulations. The microfinance industry argues that these measures limit the flexibility of MFIs and reduce their ability to serve clients, while we argue that they reduce the risk of client over-indebtedness and control fraud.

²⁷ A restriction that severely limits the ability of MFIs to operate within the schedules of clients who, for the most part, do not work in a fixed location during the work day and can only be reliably located at their place of residence at night or on the weekends (Moreno, 2014).

²⁸ Among the consumer protection initiatives that have gained importance in the microfinance sector in Ecuador is management and avoidance of client over-indebtedness, which a number of MFIs have adopted as an aspect of their social mission and organizational culture.

²⁹ For the past decade, MFIs in Ecuador have not received a significant amount of funding in the form of grants or donations. Instead, most external funding for MFIs in Ecuador now comes from international lenders who charge commercial rates of interest (Albarracín, 2014).

³⁰ Average market rates of interest are as of August 2014, according to personal conversations with microfinance practitioners in Ecuador (Albarracín, 2014; Moreno, 2014; Ríos, 2014).

³¹ For example, a loan with an interest rate of 8.5% would incur a tax equivalent to an additional 1.87% interest (Moreno, 2014).

³² However, this might change in the near future as the Government Assembly has just approved the waiving of ISD being applied to the microfinance sector, though at the time of writing this has yet to be ratified by the President.

³³ A two-year loan at 8.5% interest per year would result in an after-tax annual interest rate of approximately 13%: 8.5% interest + (22% Impuesto a la Renta ×  8.5% interest) + (5% ISD/2 years) =  12.87% (Moreno, 2014).

³⁴ Because of the high rates of interest charged by local lending institutions and the strict guarantees they require, MFIs in Ecuador typically cannot afford debt financing from within Ecuador. But rather than stifle the funding of MFIs, the government of Ecuador has made a determined effort to provide access to funding for MFIs, primarily through the creation of CONAFIPS.

³⁵ We should note that, according to Chang and Grabel (2014, p. 126), ‘the historical record shows that development success is often associated with committed—rather than disinterested—investors.’

³⁶ While funding through MIVs has made a considerable amount of international capital available to MFIs in developing countries, sharp criticism has been levied against the MIVs for their lack of transparency and lack of accountability, which create an incentive misalignment between the suppliers of capital, the MIVs, and the MFIs.

³⁷ In the microfinance market in Ecuador, where interest rates are capped, MFIs must compete on either the quality of products and services or loan size, with increased loan size offering an effective means for aggressive new entrants into the microfinance market to steal away clients from incumbent competitors. Competition based on loan size further increases the risk of client over-indebtedness.

³⁸ Most countries where microfinance operates have weak or nonexistent financial consumer protection regulations, and even where such measures have been enacted, these rules rarely cover small-scale financial services such as microfinance. The overwhelming absence of prudential regulation and supervision of the microfinance sector as well as consumer protection initiatives for microfinance clients indicates a significant and needed project for financial sector regulators around the world.