Microfinance: born in the USA? Part 2, evolution
[Continued from yesterday’s Part 1.]
Yesterday’s post explored the emergence of ’steam-powered microfinance’ from the turn-of-the-century household-finance industry, as chronicled in Funding Universe.
Another turn-of-the-century invention:
By 1900, HFC had established itself, developed a market niche, introduced its killer-app financial product – a short tenor, small personal loan for almost any purpose – and then innovated to make that product more customer-friendly. As a result, the company made branch profits that enabled it to expand rapidly, and indeed to spawn imitators, so that the housing finance industry (our ’steam-powered microfinance’) was national in scope.
Success brought a problem: while a network starts as a Pelagian ‘clean room’ environment of purity, as it scales the network goes through an infection phase.
Consumer education is painful
As public awareness of the industry grew, so did the number of reports of exorbitant interest rates and heavy-handed collection methods by some less scrupulous lenders.
It’s not precisely a paradox. A new innovation suddenly becomes wildly popular. When it does, it builds such a strong brand that the public, whose understanding has telescoped to that one attribute, cannot distinguish the genuine article from the copycat. A backlash ensues:
We’re going to regulate you
Government efforts to control loan sharks often did more harm than good by making it impossible for legitimate lenders to stay in business.
It’s not just us they’re after
Indeed, in observing the events from 1900 to 1910 — the company’s loan account decreased between 1900 and 1907; Hulbert retired in 1907, as did his successor a year later; and a number of branches were forced to close — Mackey himself was ready to retire from the field.
The same decade included a massive credit crunch – the Panic of 1907. As we are experiencing now with the subprime mess and the global credit crunch, credit crunches surface stories of bad practice.
Bad things happened to me …
Many firms go under.
It took convincing from a handful of his managers that the business could survive, and more importantly, arguments from his attorney that the industry was no less than vital to the economy, to keep Mackey from closing shop.
When the industry is infected, what heals it? The biological metaphor holds true – the organism has to manufacture its own antibodies:
Turning out new defenses to calumny
Led Industry Cleanup in the Early 20th Century
The key players were
They decided it would be a public relations boost for Mackey’s company to lead the way in cleaning up the loan business.
Leadership arises when a market participant turns on its fellow travelers who are free-riding on its successes and tarnishing its (and the industry’s) good name. But they get some help – from benevolent donors
Arthur Ham, a
Russell Sage Foundation, still going a hundred years later
Catastrophe is a precondition to fundamental reform – because only in catastrophe is there time for self-reflection.
Ham found that:
There was an enormous demand for small loans
Existing companies could not supply this demand
Most families who needed loans had no way of meeting credit demands for bank loans.
Does this give you a frisson regarding the current state of housing microfinance, or water and sanitation microfinance?
Oooo … microfinance
It should – it’s exactly the situation we find in many places throughout the global south.
He also suggested that while legitimate loan businesses could operate profitably at lower rates than they currently charged, excessive restrictions could put them out of business.
Just like microfinance today, facing a challenge of scaling up.
In defending itself against financial bacteria, the industry confronts not just predators but also overzealous reformers.
By 1913, 25 states had adopted loan legislation limiting interest rates to 6 percent.
You must remember that back then, inflation was 1-2% and legitimate interest rates were 3-4%. Still, microfinance – involving small loans and short tenors – needs higher rates than normal.
Even us legitimate bidnessmen need higher rates
Rather than be driven out of business by leaving the field empty for the loan sharks, the industry has to fight back.
When
You can never win against government by static trench defense, you have to give the elected officials something better. You have to do their work for them.
A similar law that he wrote, void of the questionable sections of Ham’s law, was upheld by the Pennsylvania Supreme Court.
There emerges the trade association of the good guys.
You know we’re good guys because we call ourselves the justice league
Thereafter Harbison, Hubachek, and Huettmann worked with Ham directly, along with a handful of others, under the name of the American Association of Small Loan Brokers, to agree upon a set of industry regulations.
The Uniform Small Loan Law was passed in 1916. This law allowed lenders to charge an interest rate of no more than 3.5% per month.
Annualized rate: 51% annually. Sounds shocking, but it’s not far off from what current microfinanciers charge.
Consumer protection is good business:
The law enhanced the public image of the industry and helped the growth of legitimate loan businesses through World War I.
And a source of competitive advantage:
For their part, Harbison and Hubachek began to develop reputations as champions of consumers’ concerns.
All this, it seems to me, is a blueprint for the microfinance industry today.
Envisioning the finance of the future
We’re throwing you out
[Continued tomorrow in Part 3.]
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