Could we see a microfinance bubble?

Vikas Bajaj’s recent article in the New York Times entitled Sun Co-Founder Uses Capitalism to Help Poor details the story of Sun Microsystems co-founder Vinod Khosla and his venture into microfinance. His recent investment in SKS Microfinance netted him $117 million after the company issued an initial public offering (IPO). The narrative of the article is that there is insufficient capital available to truly combat poverty and that Khosla is trying to channel his profits into productive outlets that will reduce poverty in a significant way. The dissent within the article is limited to the basic “you can’t put profits over people” mindset while Khosla sees N.G.O.’s as ultimately ineffective, presumably because of the lack of funding.

Aside from addressing the potential marginalization of microfinance’s noble social goals, there is a completely separate issue of the ramifications of such a flood of fund into social ventures. Money can only be a valuable resource if it can be put to good use through strong institutions and managers. Growing the budget of an organization does not necessarily result in an increase in it’s effectiveness. Even so, Kosla should be commended for his efforts to fund a wide range of social ventures such as milk collection and chilling plants which will direct cash to more than one place.

Without sufficiently strong institutions, the potential for a microfinance bubble is very real since the effectiveness microfinance depends on fiscal sustainability. The article almost gets to the point here:

Moreover, as the fallout from the global financial crisis has made clear, the profit-maximizing tendencies of businesses can hurt society, said Phil Buchanan, president for the Center for Effective Philanthropy, a research organization based in Cambridge, Mass.

A common conception about the financial crisis is that it was caused by unbridled self-interest. That is a partial answer, but the real driving force behind the crisis was that self-interest combined with an inexhaustible supply of credit in an unregulated market. Microfinance is a poverty-fighting tool which utilizes credit itself. With that in mind, could we see a Minsky bubble in microfinance as large sums of money flow into these ventures? A lack of skilled managers doing their due diligence would be another ingredient in the recipe for such an outcome. Combined with the recent IPO clouding the incentive structure of the organization, there is a risk for creating financial instability through a mechanism that was meant to bring stability to the developing world.

The fact that micro-loans are not collateralized will keep any crisis from spreading to the wider economy in the way that the housing boom of the mid-2000’s did. Nevertheless, a boom and bust of any proportion within the microfinance system would put it’s long-term sustainability in question. The real way to provide stability would be to strengthen the organizations and foster a long-term growth plan. However, the article makes clear that Khosla values the desires of wealthy donors over experienced N.G.O.’s. It will be interesting to see the ultimate impact of SKS Microfinance on the greater system and if we see some of the problems associated with for-profit lending start to creep into this form of financial services. In the meantime, the raised capital should be invested in the organization rather than used to extend credit beyond it’s scope and capability.