The big business of small loans
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Emerging Markets

The big business of small loans

Global focus on microfinance from private investors and IFIs alike has never been greater, with the industry expected to swell to $250 billion over the next decade. But expanding the sector needs more than extra funds

By Philip Alexander

Global focus on microfinance from private investors and IFIs alike has never been greater, with the industry expected to swell to $250 billion over the next decade. But expanding the sector needs more than extra funds


Small loans, it seems, are big business. Once the domain of charities and development lenders, microfinance is increasingly seen as fair game for the for-profit sector, including so-called socially responsible investors and firms whose main interest remains the bottom line. 

Wall Street too has muscled in, and several banks now have active and expanding microfinance units. One leading global microfinance investor has more than doubled its capital. Standard & Poor’s has even assigned its first rating to a collateralized debt obligation (CDO) transaction, referencing a portfolio of microfinance institutions (MFIs). 

While the surge in interest is welcome – the tool is a promising way to get credit to bits of the economy most in need of capital – it also creates a new set of challenges for a sector used to operating on the fringes of the formal economy, in developing countries where conventional banks often reach only a tiny proportion of the population.

Governments in many developing countries have woken up, especially in the past year, to the political potential of facilitating microfinance, says Elizabeth Littlefield, CEO of the Consultative Group to Assist the Poor (CGAP), a microfinance industry organization based at the World Bank. But there are still changes that are “politically awkward”, she adds, “like lifting low interest rate ceilings, which is necessary to allow MFIs to cover their costs”. 

The practical implications of this are a preoccupation for Enrique Ferraro, the managing director of US-based Accion Investments. The firm was founded in 2003 with initial capital of $20 million, and this year sealed an extra $30 million from regulated investors such as banks and private equity firms. It has stakes of up to $5 million in microfinance institutions based in 12 different countries. 

Ferraro acknowledges that MFIs in his portfolio face a wide range of prudential requirements in so many different jurisdictions, which can drive up the interest charges for clients, and even prevent lenders from reaching new customers. 

“In some countries, a regulated finance company can lend only to people who are registered with the tax authorities; you are nobody until you are paying your taxes,” says Ferraro. “The dynamic we see is that sometimes only 1% are paying taxes, so 99% are excluded from placing deposits in or taking loans from a regulated bank.”

Still, he understands the desire of the authorities to protect customers against bank failures, especially where microfinance diversifies to include fiduciary activities such as deposit-taking and insurance or pension products. In the long run, Ferraro believes the same well-regulated market procedures that work in developed countries will benefit his own activities. 

“We want to be self-regulating, to show that we can be a responsible business. But that doesn’t mean that we need to be protected or have an NGO status. The best countries for promoting access to financial services are those that have the best transparency rules, accounting rules, supervision, free competition, much more similar to the US or western Europe.” 

What matters is the willingness of the authorities to be flexible in the transition period, and he cites the positive example of certain countries in West Africa. “Instead of complying with a particular regulation, they will sign a special agreement for a temporary five-year charter to take on deposits and lend at a reduced leverage ratio, instead of the usual one-to-eight. Then later on you can access a full licence, once you’ve proved you have a solid business model.”

Wall Street takes a look

CGAP is equally keen to promote international standards of transparency and reporting among MFIs. To this end, it set up the Microfinance Information Exchange (MIX) in 2002, which now publishes standardized data on more than 1,000 institutions involved in the sector. In theory, this could also unlock the potential participation of conventional banks who want rigorous due diligence before investing in the sector. 

Citigroup, Deutsche Bank and HSBC all have active and expanding microfinance units, while Morgan Stanley arranged the four-tranche CDO transaction for Dexia’s microfinance portfolio manager BlueOrchard in May 2007, of which two tranches received investment grade ratings from Standard & Poor’s. 

In assigning these ground-breaking ratings, S&P analyst Gary Kochubka noted predictions that the total value of microfinance assets will rise to $250 billion over the next decade, from just $17 billion today – which makes it easy to understand why global players want a slice of the pie. Ferraro also underlines other selling points, including the sector’s low correlation with the performance of major economies and equity markets. 

But for now, he says that global investors are not heavily involved in Accion. “It’s not mistrust or poor profits, it’s really about size. By definition, even a portfolio of $100 million or $300 million doesn’t make us liquid enough for global banks.” Instead, he adds, smaller regional players are showing great willingness to analyze the underserved market more carefully, using microfinance to improve their local penetration.

Littlefield, who previously worked for JP Morgan, believes this is a more appropriate model in any case, and has misgivings about Wall Street muscling in. “This is not about transferring money from north to south, or about creating a new asset class. This is about developing local financial markets that serve the majority of their citizens, developing intermediation capacity between savers and borrowers and not just transferring money for loan portfolios,” she tells Emerging Markets.  She emphasizes that most poor households are net savers seeking convenient and safe deposits, which can ultimately fund microcredit activities.

Conventional banks are, if anything, learning from MFIs about more constructive client servicing, which has helped to keep charge-off rates on microcredit below 3% in many countries. 

CGAP has expressed particular concern about the case of Mexican MFI Compartamos, launched in 1990, which held an IPO of 30% of its stock in April 2007. The flotation allowed the original participants to make 270 times their initial investment on what they sold. Part of the remarkable profitability was founded on relatively high interest rates (more than 90%). Littlefield fears that, with an implied price/earnings ratio of 27x at IPO, Compartamos will be under pressure from investors to maintain those high rates to keep up that profitability, rather than passing on efficiency savings to customers in the form of lower rates.

Lessons from a veteran 

Nonetheless, Littlefield acknowledges that MFIs can benefit from outside investment to make the jump from microcredit to deposit-taking – both in terms of acquiring sufficient capital, and to introduce asset/liability management expertise. She is hoping to mobilize more resources from socially responsible investors, many of whom tend to focus purely on negative screening (avoiding arms manufacturers or polluters, for instance) rather than actively seeking to make a positive contribution.

One of the most established examples of large-scale full-service microfinance is in Indonesia, where Bank Rakyat (BRI) has for more than a century merged rural finance activities with conventional banking. At least 80% of the bank’s assets are in its Mikro portfolio, where non-performing loans (NPLs) are just 1.45% of the total. This helped BRI emerge from the 1997-98 Asia crisis as one of the few Indonesian banks still in good health, attracting the attention of foreign investors. 

The smaller conventional corporate loan portfolio has been built on microfinance, explains Sulaiman Arif Arianto, managing director of the Mikro unit and a UN adviser on inclusive banking. “Most of the corporate borrowers have been our clients for around 30 years; they started out as micro loans,” he tells Emerging Markets.

Microfinance is not a cheap business, with BRI running 4,900 outlets across Indonesia, and employing 40,000 dedicated loan officers to maintain a personal relationship with clients. The benefits are clear, however, in the low NPL rates and steadily-growing asset base. BRI has even managed to find answers to some of the toughest challenges in microfinance, including concentrated exposure to the agricultural sector that can wipe out weaker MFIs. 

“The network of loan officers allows us to separate bad borrowers from those who have genuine problems, and we match the repayments to their cashflow – for instance, leaving an eight-month gap to follow the timing of the harvest,” says Sulaiman. That said, the risk of exogenous shocks such as the 2004 tsunami or the western Sumatra earthquake earlier in 2007 requires very high levels of provisioning.

BRI launched an IPO of its own in 2003, selling a 42% stake, of which 29% went to foreign investors. According to Sulaiman, this has not led to pressure to raise microcredit interest rates, which at 27% are fairly low by international standards. Ferraro at Accion estimates that the lowest rates in the most established microfinance markets such as Bolivia are around 16–21%, and Sulaiman says a conventional bank would probably charge many of BRI’s customers more than 40%. 

“Foreign investors bought the shares because our interest margins are among the most stable in Indonesia, and our portfolio is growing,” says Sulaiman. Moreover, close consultation with the bank’s customers has taught BRI’s management that access to a wide range of straightforward microfinance products, including life and health insurance, is often more important than pushing interest rates ever lower. 

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