In a time where uncertainty in the markets is at one of its most critical points, the ability pay back one’s debt has taken center stage. The national debt of the United States has been downgraded from AAA to AA+ by Standard & Poor’s. This morning it was announced that Fannie Mae and Freddie Mac have also been downgraded.

Meanwhile, in India, similar uncertainty exists about the future viability of the microfinance model. The Wall Street Journal recently published a piece on one of the changes being tested by BASIX, a self-defined “livelihood promotion institution”. The test means that “BASIX representatives will be dispensing bank loans, rather than BASIX taking credit from banks onto its books and then assuming responsibility for the loans it issues. The bank will be able to set the interest rate and will pay BASIX a fee for handling the loan.”

The risk profile is now shifted from BASIX to larger financial institutions. Sounds like a positive, right? Let the larger financial institution who can handle more risk take it on. Here’s where it starts to get worrisome. “But [Mr. Mahajan, chairman of BASIX] said BASIX already has secured approval to lend out $56 million in bank capital. That contrasts with what he says is a total of just $5.6 million in bank loans to BASIX itself under the old model in the months since the crackdown in Andhra Pradesh in October made banks skittish about lending money to MFIs.”

The real issue at the heart of trouble microfinance is not being addressed. We have previously seen in microfinance-heavy areas that the over-saturation of the market with easy capital combined with high interest rates is a recipe for default. On a much grander scale, we have observed the effects of over-extending capital in developed nations.

The answer to microfinance’s woes is not to find ways to provide more capital. It’s to adjust the policies of vetting borrowers, practice restraint, and focus on driving impact to the Bottom of the Pyramid instead of turning a profit for the latest investor’s report.

In the new model, “the bank tells us pretty much ‘This is what we want,’ the bank ultimately approves it, we do collections and the full life cycle of the loan for a fraction of the cost” that the bank would incur if it tried to make the loan itself. One of the great advantages of microfinance is its presence in areas where banks can’t, or won’t, reach. That gives banks an incentive to pay the likes of BASIX to act as their agent.

Having microfinance organizations act as an agent for large banks spells trouble. The beauty of microfinance was their connection with the local community. Now, with incentives coming from banks to fund more loans, I worry that this will lead to yet another over-saturation of debt in the areas that can least afford another financial hit.

- Chris