Microcredit Accounting Control Fraud Deepens Bosnia’s Nightmare

By William K. Black

I write to recommend reading David Roodman’s recent column in the Washington Post (“Microcredit doesn’t end poverty, despite all the hype”).

Microcredit has been the fair-haired child in economic development despite very weak evidence that it was successful in reducing (much less “end[ing]”) poverty. It has been praised by liberals, conservatives, and feminists – an odd but strong coalition. Roodman explains that providing credit to poor people does not necessarily increase growth and reduce poverty. Roodman notes that providing large amounts of microcredit can produce bubbles. He notes that Bosnia is one of the nations that have experienced this problem, but does not note the critical article on the Bosnian microfinance crisis and he fails to mention the five-letter “f” word – fraud. Doing so would greatly strengthen his argument and demonstrate that badly designed microcredit can spur control fraud, bubbles, financial crises, recessions, and increased poverty. Roodman was writing a brief, general article about microfinance. A longer article about Bosnia’s microcredit nightmare is a good complement to his piece and I urge reading both articles in full.

The new evidence on Bosnian microcredit was presented at the annual meeting of economists this January in Chicago. The authors are Milford Bateman, Dean Sinković and Marinko Škare and the title of their superb article is “Bosnia’s Microfinance Meltdown.”

Bateman, Sinkovic, and Skare document Roodman’s worst fears. Their first paragraph demonstrates that they share Roodman’s concerns about the microcredit “hype” but go even deeper in their analytical inquiry to show why microcredit became so perverse in Bosnia.

“In this paper we challenge the uplifting narrative governing microfinance outcomes in post-war Bosnia and Herzegovina (hereafter Bosnia), and by extension in other developing and transition countries. For more than thirty years, the concept of microfinance has been lauded for its supposedly amazing power to use self-help and tiny ‘business’ projects to eradicate poverty and promote ‘bottom-up’ economic and social development (De Soto, 1989; Yunus, 1989; Robinson, 2001). The initial post-war promise in Bosnia was for poverty alleviation to be quickly secured through large numbers of sustainable jobs in microenterprises, additional income generated in the community, empowered women, an accelerated accumulation of social capital and, eventually, growing numbers of conversions of informal microenterprises into more productive formal SMEs (World Bank, 1997). However, in none of these important areas do we find that the microfinance model has generated the outcomes claimed for it: on the contrary, we document a number of seriously deleterious trajectories associated with the microfinance model that have combined, in our view, to help propel the Bosnian economy into its current deep economic crisis. In sum, we argue that the microfinance model as it has emerged in Bosnia is essentially a modified subprime-style lending program that, like the original sub-prime lending disaster in the USA (Dymski, 2009), has increasingly prioritised the private enrichment goals of senior managers quite irrespective of the enormous damage being done to the fabric of the Bosnian economy and society. Overall, we find the Bosnian case to be another example of what William Black (2005) terms ‘control fraud’ – the legalised looting and ultimate destruction of a financial institution by its senior managers.”

The authors then explained three key points that Roodman does not note but likely agrees with. Microcredit today is radically different than the original model, which involved governmental subsidies. The neoliberal embrace of microcredit led to the dismissal of the original model and the embrace of neoliberal governance, particularly executive compensation systems that are exceptionally criminogenic. Microfinance was embraced as a means of converting former Soviet bloc nations to entrepreneurial capitalism, and Bosnia was held out as the exemplar.

“To make doubly sure the microfinance model accorded with important neoliberal ‘full cost recovery’ principles, the large international donor and government subsidy component that underpinned most MFIs, especially the Grameen Bank, also had to be eradicated. MFIs were thereafter instructed to work towards ensuring their own financial self-sustainability through market based interest rates and the adoption of Wall Street-style private sector incentive structures and methodologies (Otero and Rhyne, 1994). The resulting ‘new wave’ commercialized microfinance model that emerged effectively became the only acceptable definition of microfinance (Robinson, 2001), and soon after the international development community’s highest-profile anti-poverty intervention.

Very early on the microfinance model was given special prominence in post-conflict countries and regions. Perhaps nowhere has the microfinance model been more exalted as a post-conflict reconstruction and development policy as in Bosnia….”

Bateman, Sinkovic, and Skare show that the proponents of microfinance declared that Bosnian microfinance produced exemplary results.

“A number of impact evaluations undertaken of the most important microfinance programme in Bosnia, notably of the World Bank-supported Local Initiatives Project (Dunn, 2005), claimed to find significant positive impacts. High-profile individuals soon began to claim major success, including the then President of Women’s World Banking, Nancy Barry, who strongly advised that, ‘Any war-torn country should look to Bosnia as a role model’….”

The reality was the opposite. Bosnian microfinance was becoming a disaster. The authors explain that a large portion of microfinance went to support consumption, not the creation or expansion of small businesses. They also make a point that has been almost wholly ignored in development – the implications for poverty of the failure rate for small businesses financed by Bosnian microcredit. Nearly 50% of the new businesses created failed within the year. The authors point out that such a high failure rate must produce a severe loss of wealth to the entrepreneurs’ families. The authors conclude that “many of the poor clients who have failed in their attempts to establish a microenterprise have been quietly plunged into deeper, and often irretrievable, poverty.” Worse, the authors note that one of the most important reasons for the exceptionally high failure rate of new businesses is that private sector demand is inadequate to support the existing businesses. When microfinance funds the creation of new businesses it tends to increase the failure rate of existing businesses.

Fraudulent CEOs of microcredit firms (MFIs) typically chose to create perverse financial incentives by their loan officers that guaranteed catastrophe.

“Even though ‘saturation’ was manifestly evident by mid-2005/6 (Bateman, 2006), even more rapid growth of MFIs was proclaimed as important in order to satisfy supposedly ‘unmet demand’ for microloans. Predictably, multiple borrowing soon became one of the most serious client problems in Bosnia: a major survey of MFI clients found that 58% of clients were holding more than one active credit contract, with more than 32% of clients holding three or more active credit contracts (Maurer and Pytkowska, 2011: 3).

Moreover, even though a functioning public credit bureau has existed in Bosnia since 2003, as well as a private credit bureau, very few MFIs were interested to pay for any potential client data from these institutions. When the overarching goal is to find as many clients as possible, and given that bonus payments were a large part of a loan officer’s monthly salary and these bonuses largely depended on bringing in new clients, there is little incentive to exercise such caution.

By 2008, the end was in sight, and there was a double digit increase in the number of non-performing microloans. By 2009 around 28% all MFI clients were described as ‘seriously indebted or over-indebted’, which further breaks down to 17% being in a situation where the monthly repayment now exceeds the total household disposable income, with the other 11% operating just under that threshold (ibid: 4). It is also the very poorest that are in serious debt, with the incomes of those over-indebted found to be more than half that of those not overindebted (ibid: 4).”

At this point we know that the pattern of lending makes no sense for an honest lender. As the glut of loans increases the fraudulent CEO of the microfinance lenders raced to increase lending. The CEOs put their loan officers on compensation systems that create perverse incentive to make vast numbers of bad loans. Bosnia had a system of credit checks, but the CEOs controlling the fraudulent microfinance lenders did not want to document that they knew the loans they were making were bad loans.

Each of these perverse steps was consistent with the recipe for optimizing accounting control fraud. The four ingredients are:

Grow extremely rapidly by
Making bad loans at a premium yield while
Employing extreme leverage, and
Providing only grossly inadequate reserves against the inevitable losses

George Akerlof and Paul Romer, in their famous 1993 article about accounting control fraud (“Looting: the Economic Underworld of Bankruptcy for Profit”) emphasized the proverbial bottom line by showing that this fraud scheme was a “sure thing.” It was guaranteed to make the CEO wealthy and it did so quickly. Bateman, Sinkovic, and Skare found that Bosnian microcredit exemplified this “sure thing.”

“The often stunning Wall Street-style salaries, bonuses, share options and other rewards that senior managers of MFIs deem they deserve have become one of the most grotesque features of the ‘socially-oriented’ microfinance industry, notably in India and Mexico. The rapidly growing number of ‘microfinance millionaires’ (Bateman, 2010) has resulted in a loss of respect for the microfinance model among the rich and poor alike. Similar anti-social dynamics have emerged in Bosnia. First, Bosnia’s statistical services have been reporting for some time that the senior managers working in the country’s microfinance industry are now routinely among the highest paid individuals in the country. Adverse media comment is rising fast, forcing most MFIs into undertaking more PR events and lobbying in order to maintain their popular and, more importantly, political support. But citizen and government disenchantment with the microfinance industry continues to rise. Mujković (2010: 6) reported that MFIs in Bosnia were increasingly seen to be “exploiters who are charging exorbitant interest rates on loans to poor populations”. Much of the remaining trust in the microfinance sector was then lost in 2011, moreover, when the Bosnian statistical service announced in one of its regular bulletins that the highest paid individual in Bosnia was the Director of an MFI (Mikrofin), an individual who in July 2010 received a taxable monthly income (salary plus bonus payment) of 220,249 KM (around $US150,000). In a country where the average monthly salary is around $US600, even long-time microfinance supporters were deeply embarrassed at this latest Wall Street-style turn of events. After long claiming that microfinance was all about ‘assisting Bosnia’s poor to escape their poverty’, and after very significant grant funding from the international development community actually

provided the initial capitalisation for virtually every MFI (Agencija za Bankarstvo Federacija BiH, 2011: 25), many ordinary Bosnian people now feel that they have effectively been abused by the microfinance industry, not assisted to better their lives.”

Bateman, Sinkovic, and Skare recognized that what they were finding was accounting control fraud. Their explanation turned me into an adjective.

III. Bosnia is a clear case of Blackian ‘control fraud’Finally, we found in the model of ‘control fraud’ developed by William Black to explain the rise and fall of the US Savings and Loans Institutions (S&Ls) in the 1980s, a very useful explanatory framework with regard to the emerging structure, conduct and performance of Bosnia’s microfinance sector. First, Black’s model correctly predicted that senior managers in Bosnia’s MFIs would insist on an unsustainable growth strategy, but would nevertheless be able to convince all external parties (e.g., auditors, regulators, the media, the international development community) that it was a sound strategy. Second, Black’s model correctly predicted the methods variously used by senior managers to privately enrich themselves, such as their attachment to inordinately high salaries, regular bonuses, awarding of share options, use of interest free loans, and so on. Third, Black’s model correctly predicted that senior managers would eventually begin to convert the MFI’s assets (original grant funding plus retained profits) into their own private assets, such as when senior managers take a private stake in one of the MFI’s new investment projects, often using favourable loans obtained from their own MFI to do it. Fourth, Black’s model correctly predicted that senior managers would exhibit a visceral hatred towards, and attempt to frustrate, all Bosnian government regulators and any others who might try to properly regulate or monitor the microfinance industry. Fifth, Black’s model correctly predicted that senior managers would seek the psychological rewards associated with being the most profitable MFI, as well as adulation from elite opinion makers, including regular appearances as invited ‘experts’ at high-profile international donor events.”

I add only one clarification. Fraudulent CEOs convert firm assets to their personal benefit primarily through the perverse compensation systems that the authors rightly criticize. The recipe produces the “sure thing” – high levels of fictional income – that produces extreme CEO compensation.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack