Reading the reports coming out of Andhra Pradesh (AP) almost by the hour, anyone must surely feel a mixture of emotions – sadness, despair and, probably, growing anger too. What is happening in AP today is an economic, social and humanitarian disaster. Mounting individual indebtedness in the poorest communities (large thanks to the ease in obtaining multiple loans), artificially inflated and distorted local economies (many inflated into nothing more than giant bazaars and permanent street sales), spectacular levels of profiteering by the CEOs and key private investors attached to the main MFIs, increasingly aggressive loan recovery techniques, and growing numbers of reports claiming multiple cases of suicide that apparently directly followed on from such aggressive loan recovery techniques (see Microfinance Focus Serp Report ). Any which way you look at it, this is not a good advertisement for the ‘microfinance-as-poverty-reduction’ model, and in a region that was long held up as a spectacular positive demonstration of the far-ranging ‘bottom of the pyramid’ impact of the commercialized microfinance model. Moreover, often held up as important examples of a new type of business, a so-called ‘social business’, their activities to date do not suggest that this new business structure operates in favor of the poor as much as is all too often naively claimed for them.
What we are seeing today in AP, in actual fact, is the beginning of the end of AP’s commercialization-driven microfinance ‘boom’. This disastrous trajectory can be traced back to the 1990s when the state began to withdraw from the provision of rural finance, and the resulting vacuum was filled by private profit-seeking institutions, private moneylenders, and a number of NGOs.The expansion of microfinance was then massively hiked up from the mid-2000s onwards, thanks to the arrival on the scene of a number of aggressive commercialized for-profit MFIs. The most notable of these, of course, is SKS. Today, AP is now second only to Bangladesh as the most microfinance ‘saturated’ place on earth, with a full 17% of the population in possession of a microloan account (Microfinance bubble – South India). That this represents a massive over-supply seems clear to Rozas, and it should be clear to all based on even the most cursory glance at the evidence emerging to date: the number of multiple loans was already a huge 82% in 2006, and it’s known to have risen even further since then; the level of debt in the important agriculture sector has continued to rise as well (around 82% of farm households were in ‘serious debt’ in 2003 compared to the Indian average of 49% and this figure too has been rapidly rising); by the amount of hard-selling and ‘client poaching’ now required to find and sign up new clients; by the amount of pressure on existing members to take out a new or ‘top-up’ microloan; by the rising percentage of problematic microloans; and by the rise in suicides that just might (but might not) be associated with increased levels of hard-to-repay micro debt. Tragically, this was a ‘boom-to-bust’ crisis foretold. Along with the Bolivian microfinance crisis of 1999-2000, the precursor (mini-crisis) to today’s full-blown crisis that took place in AP itself in 2006, the series of boom-to-busts that have occurred in Bosnia, Pakistan, Morocco, Nicaragua and elsewhere in recent years, and let’s not forget to the granddaddy of them all – the sub-prime-led financial sector meltdown in the USA from 2007 onwards -, there were, in fact, a whole street full of red lights flashing to warn policy-makers to avert the massive over-expansion of microfinance in AP. Many knowledgeable microfinance analysts/supporters in AP itself were warning that a meltdown was coming and that it would be an outright tragedy for the poor. Notably, microfinance analyst Daniel Rozas felt distinctly uncomfortable about the trajectory, and in late 2009 penned a report to that effect (see above). Back in early 2010 (Economic Times, 8th March 2010), microfinance pioneer Vijay Mahajan was also lamenting the situation, among other things pointing out that the level of multiple borrowings was rising very alarmingly indeed, and most individuals used a microloan simply in order to repay old microloans, and only very rarely for productive investment. Mahajan correctly foresaw real problems ahead in AP (though, somewhat puzzlingly, he was unable or unwilling to do anything in his own MFI – BASIX – to help avert the crisis, such as drastically curtailing its own lending activity). In fact, all the main commercialized MFIs appear to have had such momentum behind their own expansion that they simply could not be stopped: more to the point, they did not WANT to stop and let other MFIs win market share. To labor a by now well-worn phrase – so long as the music continued to play, all the MFIs in AP felt that they had no other option but to keep on dancing. This is the financial economics of the madhouse
But at least the massive expansion of microfinance been a good thing for the poor?
The various PR departments and a handful of CEOs appear to have agreed on the line they had to take when faced with the prospect of being forced into slowing down their reckless growth rates: the poor would suffer if the MFIs stopped growing. This response was disingenuous at best, if not palpable nonsense. No solid evidence has emerged to date to confirm that the net position of poor communities in AP has been improved thanks to the arrival of microfinance in the 1990s, just as we do not find any solid evidence that the huge quantities made available to the poor everywhere around the globe since the mid-2000s have had a positive impact (A Sobering Assessment of Microfinance’s Impact ). In fact, a careful reading of the evidence (for example, see the excellent work of Aneel Karnani) demonstrates that microcredit has been of little long-term help to the poor, not just in AP but right across India. Just one of the overarching problems raised by Karnani is that small and medium business with some growth potential, and family farms with a possibility to scale-up and integrate into local agricultural supply chains, have been largely ignored. One might say it is a problem of ‘stuffed and starved’ (apologies to Raj Patel) – microenterprises and self-employment have been ‘stuffed’ full with microfinance, whereas potentially high(er) growth SMEs and family farms have been ‘starved’ of the financial resources they needed to expand employ more workers, train their staff, adopt important innovations, seek out export markets, integrate into local supply chains, and so on. The opportunity cost of microfinance in AP so far, I would thus argue, has been simply huge. Alongside this are a number of other problems. One is the increased indebtedness and intractable poverty often caused by the high rate of failure of microfinance-induced microenterprise projects. For example, the George Foundation undertook a study in 17 villages and of over 50 microcredit programs in South India, with the study finding that less than 2% of microenterprises were in existence after the first three years (see Abraham George, India Untouched: The Forgotten Face of Rural Poverty. Writers’ Collective, 2005). As everywhere else – though few researchers choose to explore this awkward area – those failing in their attempt to establish or expand a microenterprise often plunge into much deeper poverty. Deep-down I suspect many CEOs and MFIs are fully aware that microfinance ‘saturation’ in AP has achieved very little for the poor, and are just pressuring the poor into micro debt peonage for no really good reason other than that it is primarily in their own interest to do so ( Quest for fast growth lands Indian MFI’s in Soup ). Instead of redesigning or restructuring their policies and programs to more meaningfully address poverty and underdevelopment in the face of little impact, the microfinance industry has simply turned the preferred poverty reduction instrument (microfinance) into the poverty reduction metric itself (more microfinance equals more poverty reduction).
GETTING TO THE ROOT CAUSE OF THE PRESENT CRISIS IN AP
So, much ink has been spilled as to what is the root cause of the current crisis. Blame has been cast upon the global financial crisis, India’s politicians, the poor infrastructure, incompetent newspaper reporters, Rahul Gandhi supporters, and so on and so forth. Those warning of the rising indebtedness of the poor were often attacked. Wall Street journalist intern, Ketaki Ghokale, for example, was one of the first to bravely report that ‘something is going wrong’. She produced in 2009 a well-written report that illustrated important aspects of the mounting debt crisis in AP and correctly predicted events that have since transpired. It was never meant as a scientific analysis, but the opprobrium heaped upon her from all sides in AP and by some high-profile researchers abroad was quite sickening. The message I took away from this wholly unjustified negative reaction was that she was simply NOT going to be allowed to spoil the party that was underway. Many other individuals were personally smeared for having the temerity to raise their own very real concerns about commercialized microfinance, including myself (Why Microfinance doesn’t Work Review-David Roodman ). Almost all of the talk in the Indian press so far, moreover, has merely addressed the symptoms of the present microfinance crisis. Lost in all this is the pressing need to begin to get to the root cause of the current crisis because only then do we have a chance of addressing the current crisis, as well as hopefully preventing similar crises from occurring in other developing countries in the future. And there can be no doubt whatsoever what the real driving force behind the current crisis is: it is clear, and overwhelmingly, a result of the largely ideologically-driven move to commercialize microfinance. This movement began in the 1990s through USAID and CGAP pressure to cut the costs of supporting the poor and enthusiastically implemented in the field by such as ACCION. However, by turning MFIs into for-profit units, aided by extensively deregulated operating environments, and increasingly incentivized by Wall Street-style freedoms and private enrichment mechanisms (share options, bonus pots, high salaries, IPOs, and so on), the stage was inevitably being set for an explosion of unethical behavior, serious mission drift and, worst of all, microfinance ‘boom-to-busts’ right around the developing world.
IN AP AT LEAST FOUR MAIN MECHANISMS EMERGED TO KEEP UP THE PRESSURE TO ACCELERATE THE SUPPLY OF MICROFINANCE WHATEVER THE EFFECT UPON CLIENTS:
1). The MFI’s managers wanted to ramp up their own salaries or to strike a better personal financial package (salary, bonus, share options, etc) when their turn for an IPO comes around 2). The MFI’s loan officers wanted to earn higher bonuses. 3). The MFIs employees wanted to cash in the large part of their remuneration that was given in the form of shares and share options. 4). Shareholders/investors wanted to earn higher dividends and eventually inflate the value of their shareholdings. Given these incentives, probably no amount of careful studies, penetrating analysis, or even an AP version of Nouriel Roubini, would have made a blind bit of difference to the ultimate ‘growth at all costs’ trajectory that began to take shape. In other words, just as in the US sub-prime-driven crisis, the root cause of AP’s microfinance crisis lies in the nature of the commercialized ‘grab what you can’ financial model that was adopted.
The situation in AP is yet another example of ‘control fraud’
Digesting all the recent reports in AP, and exploring the underlying structure of the microfinance industry in AP (and elsewhere where commercialization has taken hold), it seems clear that the most satisfactory explanatory framework for the crisis events in AP is to be found in the concept of ‘control fraud’. This is a concept developed by the criminologist-economist William K. Black of the University of Missouri-Kansas City, probably the world’s leading systematic analyst of the relationship between financial crime, financial structures and incentive mechanisms. In the 1980s, Black was one of the financial regulators in the USA who helped to expose the ‘legalized frauds’ being perpetrated by the Directors and senior managers in the Savings and Loans (S&L) Industry, a sector that first rose magnificently and made super-profits for a small number of senior employees, but which then collapsed causing huge economic damage to the US economy and also eventually necessitated a US taxpayer bail-out to the tune of more than $124 billion. Black defines ‘control fraud’ as the legalized looting of an organization by its senior managers. Importantly, ‘control fraud’ has two meanings: it is the descriptor for the situation where CEOs and a small number of senior colleagues have been able to loot the financial institution they are employed by and also own (fully or partly); it is also the descriptor for the individuals themselves that actually engage in this looting process. To grasp Black’s overall take on the matter right away, one need look no further than the title of his seminal 2005 book; ‘The Best Way to Rob a Bank is to Own One.’ (published by the University of Texas Press). In this major work and others, Black explains at length why it is that unethical, but often wholly legal (at least initially), private enrichment is made possible and almost inevitable once a small group of key individual managers ends up ‘capturing’ the community-based financial institution in which they work. A smart CEO would not simply transfer an institution’s cash to his own bank account on some remote foreign island: the chances of eventually being caught are way too high, and unless you want to spend your life in exile or in prison, this is not the way most savvy CEOs do business. There is a much better way to get spectacularly rich according to Black. Through insinuating ones-self into an ownership and control position within one’s financial institution one can loot that institution in an almost entirely legal way: there is no need to steal. Black (2005; page 2) notes, for instance, that ‘Well run companies have substantial internal and external controls designed to stop thieves. The (..) CEO, however, can defeat all of those controls because he is in charge of them’. The biggest allies of control frauds, Black contends, are the rating agencies and top audit firms who routinely provide a clean opinion in return for a package of financial and non-financial favors flowing in their direction. Black originally had in mind the (then) ‘top 8’ audit firms, including the Arthur Anderson group, made bankrupt and broken up after its many failures in relation to Enron were finally exposed. But his analysis almost perfectly applies to the egregious recent failures of the ‘top 3’ US rating agencies, who for exactly the same reasons were found to be more than willing to deliberately over-value huge volumes of toxic assets, and thus ended up helping to bring about the current global financial crisis. Even worse, Black reports that control frauds all too often move into accounting fraud, inflating income and hiding losses in the most insolvent institutions in order to keep up the pretense of a solid financial institution, but in reality, only keeping it going in order to extract as much personal wealth as possible before it crashes. Black reports (2005: 3) how the extensively deregulated environment in the USA made it so easy for control frauds in the S&L episode to become expert at ‘(using) a fraud mechanism that produced record profits and virtually no loan defaults, and (gave them) the ability to quickly transform any [real] loss found by an examiner into a [fictitious] gain that would be blessed by a Big 8 audit firm’.
Black describes a number of other important techniques deployed by the savviest and aggressive control frauds:
- Control frauds often use an institution’s own resources to buy their way into that same institution. Typically, interest-free loans are used to facilitate the CEO and close associates becoming the majority owner(s) of their own institution. In some countries, such arrangements are illegal (including I understand in India too), but in some other countries, the rules against such an act are unclear, and anyway avoidable with good legal advice. In AP there is important evidence that several key individuals within the AP microfinance sector have used this technique to buy into their own MFI.
- Control frauds have no problem using the institution’s own funds to change the external regulatory environment in its favor. As Black says (2005: page 3), ‘political contributions and supportive economic studies secure deregulation. Control frauds use the company’s resources to buy, bully, bamboozle, or bury the regulators’. In AP recent events demonstrate that the microfinance sector is more than willing to very aggressively ‘go after the regulators’ in order to maintain a regulation-free microfinance industry (or to maintain a self-regulated microfinance industry, which is essentially the same thing, as we have seen this last five years in the lead up to the crisis).
- Control frauds create what Black calls a ‘fraud friendly’ corporate culture by hiring yes-men (and firing them when they cease to be so) and ego strokes (conspicuously praising the employees at all times), but also use aggression and terror to get employees to do what is required of them. Black concludes that control frauds are usually ‘control freaks’. In AP the microfinance sector has a legion of ‘yes-men’ (and ‘yes-women’) at its disposal, but it has also been quite brutal in dismissing staff, even CEOs if they do not fit in with the plans being hatched by the ultimately most powerful control fraud.
- Control frauds almost always grow rapidly and often recklessly through speculative activities, refusing to learn from experiences elsewhere that such behavior might compromise the institution and might not be in the public interest. They also seek to report fantastic profits, which are routinely vouched for by the top audit firms. Pointedly, Black notes (2005; page 4) that, ‘control frauds are human: they enjoy the psychological rewards of running one of the most “profitable” firms. The press, local business elites, politicians, employees, and the charities that receive (typically large) contributions from the company invariably label the CEO a genius’. In AP several of the largest MFIs (notably SKS and Spandana) have been securitizing their microloan portfolios with the larger commercial banks. As now know with awful clarify from the US sub-prime crisis, this technique carries huge dangers because it greatly reduces the incentive on the part of the MFI to ensure that their clients are in a position to repay, since any future loss from non-repayment will have by then been transferred across to someone else.
- Control frauds, above all else, Black contends, exhibit a desperate need to grow their financial institution as rapidly as possible, regardless of the external or longer-term consequences. Some control frauds descend into pushing outright Ponzi schemes, with the CEO and his allies extracting a percentage of the take. Most CEOs, however, desire to grow enormously fast simply in order to cover their rising salary and bonus payments. It is this dynamic that accounts for the ‘rapid growth at all costs’ seen in all historical episodes of control fraud, including the S&L crisis in the USA. In AP the spectacular growth of the microfinance sector has been widely noted. The key figures in the microfinance sector have consistently reported that this is their main goal – to ensure every last poor person in AP has a microloan in their possession in order to escape poverty. But most analysts are coming around to accepting that this was always a largely false pretext: rapid growth was pursued simply because it enabled a set of other personal and institutional goals to be attained quite unrelated to improving the situation of the poor. This growth dynamic, perhaps more than any other issue, explains the events and adverse dynamics that have effectively destroyed the microfinance sector in AP. The control fraud structures Black describes originated out of his analysis of the actions responsible for the destruction of the USA’s S&L industry in the 1970s and 1980s. These control fraud actions were also variously deployed afterward by a good many unethical companies (Enron, WorldCom, Global Crossing), leading to some equally horrendous economic and social outcomes. I would argue control fraud is now leading to the destruction of the microfinance sector in AP too. The control fraud structures Black describes almost perfectly reflect the commercialized Wall Street-style structures that the microfinance industry worldwide – but especially in Ap – has been encouraged to adopt since the 1990s. Similarly, destructive outcomes as in previous historical experience should, therefore, come as no surprise. Black’s theory and analysis of control fraud provide the most appropriate explanatory framework for understanding the most important dynamics and trajectories that have undermined the microfinance industry in AP and more generally worldwide – these are: how and why so many of the largest MFIs in AP were ‘captured’ by their senior managers, the methods this new group in AP were able to use to make their own private enrichment the operative goal of the(ir) MFI, their extreme antipathy to all forms of externally-imposed regulation and monitoring in AP and nationally, and – crucially – why the process is so hugely destructive to the public good in AP. We should also note that a large number of MFIs outside of AP clearly fall into the category of control frauds: notably Banco Compartamos in Mexico. Control frauds are best seen as a set of arrangements that are always unethical, and virtually always highly inefficient for society and the poor, but very often perfectly legal arrangements (at least initially). Sometimes, there is outright illegality right from the start. But in such circumstances, Black maintains, the most successful control frauds turn out to be associated with those individuals (CEOs) who can best accumulate and deploy the power to change (deregulate) the regulatory environment in their favor. Control frauds are experts in turning what might be illegal behavior and activity one day into a perfectly legal behavior and activity the next. The most destructive aspect of control fraud, however, is that it significantly increases the chances that financial institutions and the entire financial sector will ultimately be destroyed. Black points out that the US taxpayer was eventually left with a bill of $124 billion to restructure the US financial sector when the S&Ls eventually exploded. And, of course, we now know that the global financial, economic and social cost of the control fraud-driven sub-prime loan crisis in the USA is going to be substantially more than anything we have encountered to date (topping even the losses incurred to fix the financial system in the 1930s). Does one wonder what will be the final cost to the Indian and AP taxpayer of eventually fixing its own control fraud-driven microfinance sector?
