Microfinance Perspectives For A Socially Motivated Investor

This chapter is designed to enlighten essential notions of microfinance and provide an overview on microfinance institutions.

2.1 Notions of microfinance

“The poor stay poor, not because they are lazy but because they have no access to capital.?

Milton Friedman, 1976 Nobel Prize in Economic Sciences

One of the critical aspects that impacts adversely growth in the developing world is that a major part of its population is excluded from financial services (Yusuf, 2009). The vulnerability, those people face, could be reduced when means that smooth consumption and overcome crises are provided. Like any individual they need a full range of financial services, rarely accessible through the mainstream financial sector. [1] 

2.1.1 Microfinance: a concept to alleviate poverty

Microfinance means financial services for low-income people, mainly to set up and grow businesses. There are many definitions of microfinance, and the concepts show a discrepancy. According to the Consultative Group to Assist the Poor (CGAP) [3] In order to frame the scope of microfinance, CGAP (2004) developed a list of key principles for “effective, accessible and equitable microfinance services?. The Key Principles for Microfinance (refer to Appendix I) were endorsed by G8 leaders in 2004.

Based on Stuart Rutherford research, CGAP (2006, p.22) distinguishes three functions describing the expediency of microfinance. First, microfinance provides low-income people with the ability to deal with life-cycle events, e.g. marriage, death and education. Second, microfinance reduces vulnerability by increasing the aptitude to deal with emergencies, e.g. personal crises and natural disasters. Third, microfinance provides opportunities to invest in “an existing or new business, or to buy land or other productive assets? (Rutherford, 2000, p.8). In addition, microfinance in Latin America is slightly narrower, though linked to the third aforementioned function. Berger & al. (2006, p.4) define microfinance in Latin America as “financial services primarily for microenterprises: their owner/operators and their workers. […] Microenterprise has a broad definition; it includes independent economic activities ranging from individual vendors selling oranges on the street to small workshops with employees—and anything in between.?

It seems to be a general statement, supported by all actors involved in microfinance, to focus on those excluded from the formal financial sector. The very essence of microfinance is to give the individual the tools to develop him- or herself.

Give a man a fish and you feed him for a day. Teach him how to fish and you feed him for a lifetime.

Lao Tzu

Targeted microfinance clients are identified by certain characteristics: gender, ethnicity, caste, religion, geographic location (e.g. rural or urban) and poverty level (Ledgerwood, 1998). In referring to microfinance clients by poverty level, Cohen & Sebstad (2000) separate them in four groups. Most current microfinance clients seem to fall around or just below the poverty line.

Vulnerable non-poor clients are in households above the poverty line but are susceptible to slipping into poverty.

Moderate poor clients are in the top 50 percentile of households below the poverty line.

Extreme poor clients are in households in the bottom 10 to 50 percentile of households below the poverty line.

Destitute clients are in households in the bottom 10 percent of households below the poverty line.

Figure 2.1: Defining Microfinance Clients

Source: CGAP (2006) based on Cohen & Sebstad researches

Cohen & Sebstad (2000) find out that microfinance clients come from extreme poor, moderate poor, and vulnerable non-poor households. People coming from destitute households seem not to be reached by microfinance. Amongst few exceptions, the largest number of microfinance clients appears to be moderate poor people (Figure 2.1).

Latin American microfinance makes no exception; it focuses on entrepreneurs with insufficient access to financial services and the unbanked in general, including both the poor and clients above the poverty line. Latin American microfinance aims to provide services to a broad base of clients (Berger & al. 2006), rather than focusing on the poverty issue.

Therefore microfinance doesn’t coincide with charity. Microfinance might be a long-term sustainable approach to alleviate poverty as contrasting with a single donation. Reformulating Friedman’s quote, people in developing countries do not lack entrepreneurship, they lack access to capital, and economic growth might be limited without capital formation (Honohan, 2004). On the first sight, it might contradict traditional development work. However the whole idea is to help low-income people to independency from aid.

Traditionally microfinance aims to reach female population (e.g. Grameen Bank). Women are often discriminated in developing countries; they hardly have access to capital. Formal-sector commercial banks tend to favor men; consequently women seek solutions through the informal sector (Armendáriz & Morduch, 2005, chap. 7). The issues surrounding microfinance and gender equity are often sources of discord among academics and practitioners.

On the one hand, empirical results seem to confirm that microfinance contributes to increasing women’s empowerment (e.g. Pitt & al. 2003). On the other hand, Nowak (2005) notices in Bangladesh that this empowerment might exclude men from the labor market. Women tend to be more conservative in their investment strategies (Armendáriz & Morduch, 2005, p. 183), they are better at repaying their loans and more willing to co-operate with their loan groups [1] . However women often act merely as intermediaries for their family, such that the men spend the contracted loan, while women are burdened with the inherent risk. Thus women are kept out of waged work and pushed into the informal economy (Cons and Paprocki, 2008).

2.1.2 Microcredit: a tool to alleviate poverty

Microcredit is one of the major components of microfinance. For a matter of illustration, Latin America is a relevant example highest microcredit penetration rates in the world, where Peru, Paraguay and Chile have penetration rates between 25% and 35%. [4] , but can be more consequent depending on the country. Conversely, microcredit is hard to be defined rigorously with respect to the size of the loan, e.g. $300, $500 or $1,000. Berger & al. (2006, p.4) argue to avoid a strict microcredit threshold definition because of different levels of development, incomes, and prices existing across countries. Table 2.1 provides figures in regards to average loan sizes by region as of December 2009.

Table 2.1: Average loan balance per borrower by region

AFR

EAP

ECA

LAC

MNA

SAR

All Regions

Avg. Loan Balance per Borrower (in $) [1] 

626

684

4008

1341

746

912

1588

Avg. Loan Balance per Borrower

(in % of GNI per Capita) [2] 

138

48

155

47

44

115

97

Source: based on MIX (2010)

Secure jobs and reliable sources of income elude the poor. To get by one can create and run its own microenterprise. The latter may be small, but the cumulative impact is colossal. Depending on the country, microenterprises employ an estimated 30% to 80% of the working population (United Nations, 1997). Even if a recent study (Roodman & Morduch, 2009) raises grave doubts about the poverty impact of microcredit (or more generally microfinance), its objective remains to enable people to work their way out of poverty. [3] 

As a weapon for fighting poverty in the developing world, microcredit is as vital as education, health care, human rights and stable government (Smith & Thurman, 2007). To emphasize its importance in fighting poverty, the United Nations declared 2005 the International Year of Microcredit [4] . This associates with the Millennium Development Goals, where one of the purposes by 2015 is to decrease by 50% the proportion of people living currently in extreme poverty. Microcredit is important to get a deeper understanding for the transition process to sustainability for the microfinance area since this, in the long-run, might be an excellent approach for “any practitioner of development and for those eager to change the way financial institutions, international agencies and private actors service poor populations throughout the world? (UNCDF, 2005). The essence and driving force of microfinance is to create an environment for development and independency for low-income people and, in a wider perspective, for nations.

2.2 Microfinance institutions: the micro level

Schumpeter (1911) argued that the advanced services provided by financial intermediaries - like mobilization of savings, allocation of capital, management of risk, facilitating transactions and monitoring firms- are essential for economic growth and development. Hence appropriate financial intermediaries might play a central role in the developing world by providing financial services that “stimulate economic growth by increasing the rate of capital accumulation and by improving the efficiency with which economies use that capital? (King & Levine 1993, p. 735).

2.2.1 Definition and overview

A microfinance institution (MFI) is an organization that provides financial services to low-income clients who are not served by mainstream financial service providers (Mersland & Strøm, 2009). MFIs play a significant role in facilitating financial inclusion [2] .

Characterizing the microfinance industry, reliable and inclusive data is complex to come by, regarding market penetration particularly. According to Daley-Harris (2009) 3552 MFIs worldwide reported reaching approximately 155 million microfinance clients as of December 31, 2007, where 83.4% are women.

Besides, the Microfinance Information eXchange (MIX) [4] for comprehensive figures on market coverage. Combining the three sources, 2420 MFIs reported reaching 99.4 million microfinance clients in 117 countries. Most MFIs in this sample are concentrated in South Asia and Sub-Saharan Africa, while most borrowers are concentrated in South Asia, and East Asia and Pacific region (MIX, 2008).

Figure 2.2: Regional distribution of microfinance clients Figure 2.3: Regional distribution of MFIs

Source: own research, based on MIX (2008)

As the MIX (2008) disclaimer advises, these numbers should not be considered exact representations of the global figures. Not all MFIs and microfinance clients are covered in the sample. The figures correspond to a sample of MFIs that self-reported. MFIs that voluntarily provide their information tend to be more efficient and well-managed than the majority of MFIs; subsequently the aforementioned numbers are not perfectly accurate. This discrepancy might be explained by a significant number of informal operators characterizing microfinance.

2.2.2 Microfinance institutions in the landscape of financial service providers

The organizational structure and management in combination with the degree of oversight of supervision by the government determines the institutional formality of MFIs (CGAP, 2006).

Figure 2.4: The spectrum of financial services providers

Source: CGAP (2006, p.36)

Low-income people largely obtain financial services through informal arrangements. Arrangements may well be made amongst friends and family, or with saving collectors, shop keepers, and moneylenders. Often despised for exploiting low-income people, moneylenders in fact “offer a valued financial service in many communities? (CGAP 2006, p. 37).

Cooperative financial institutions are member-based organizations, owned and controlled by their members. Financial cooperatives are generally not regulated by a state banking supervisory agency, but they may be supervised by a national or regional cooperative council. Financial cooperatives are chiefly non-profit institutions.

Non-governmental organizations (NGOs) have been the true pioneers of microfinance. According to CGAP (2006), at least 9000 NGOs are providing financial services. NGOs may face constraints in the range of financial services that they are authorized to provide; e.g. NGOs may not be allowed to offer deposits-taking services. Most of Latin American MFI pioneers began as NGOs, working in urban markets. They have focused on microcredit as the primary service offered, only recently beginning to develop their product range (Berger & al. 2006, p. 41).

The existence of microfinance is owed to the lack of ability or inclination of formal financial institutions to serve the unbanked. On the other hand, these institutions have the means to make the financial system truly inclusive. CGAP (2006, p. 49) considers state-owned banks as “immense sleeping giants [that] could play a big role in scaling up financial services for the poor?.

Amongst private commercial banks four types of institutions can be distinguished:

Rural banks have emerged in specific countries. They target clients in non-urban areas generally involved in agricultural activities.

Non-bank financial institutions (NBFIs) include both for-profit and non-profit organizations. A separate license for NBFIs may exist in return for being allowed to assume additional roles, including, for some, taking deposits (Cull, Demirguç-Kunt & Morduch, 2008). NBFIs encompass mortgage lenders, consumer credit companies, insurance companies, and certain types of specialized MFIs.

Specialized microfinance banks entail transformed NGOs, NBFIs, and banks that from their establishment were entirely dedicated to microfinance.

Commercial banks are fully licensed financial institutions regulated by a state banking supervisory agency (CGAP, 2006). Commercial bank MFIs are likely to be pro-profit and rely to a larger extent on commercial funds (both debt and equity funding) and deposits. This category consists of both microfinance banks with microfinance as their main activity as well as of number of commercial banks who established specialized departments within the bank to focus on poorer clients.

2.2.3 Specific features and lending methodologies of microfinance institutions

The contrasts between MFIs and the mainstream financial institutions are important to be mentioned at this stage. Honohan (2005, chap. 3) provides three major dimensions along which microfinance appears to be dissimilar to the mainstream: scale, subsidy and style of operation.

Scale can be perceived as a transitional phenomenon and the sustainability of an MFI is partly a function of scale. Rather than having a large number of MFIs, achieving scale of individual institutions, “seems to be the key to ensuring that the sector has reached a large proportion of the population? (Honohan 2005, p. 12). Moreover, one has to emphasize the importance of achieving scale when region-wide economic shocks occur. The latter can plunge apparently households into poverty. Hence small-scale, informal and geographically confined financial arrangements are “unable to dissipate the risk through pooling? and (geographical) diversification Honohan (2005, p. 13).

Style of operation differs between microfinance and the mainstream. It is important to realize the diversity within microfinance itself. The lending methodology is a major feature of an MFI. Cull, Demirgüç-Kunt & Morduch (2007, 2009) distinguish between three lending methodologies for providing microcredit; the individual methodology and two group-lending-based arrangements.

The individual lending method applies to MFIs that use standard bilateral contracts between a lender and a single borrower. Solidarity group lending applies to institutions that use contracts between a lender and a solidarity group of borrowers. Loans are made to individuals, but the group is confronted to a joint liability for repaying the loan. The village bank methodology applies to institutions that offer large groups the opportunity to engage in participatory lending by forming a single branch. Being of the major innovation of the microfinance movement, the practice of group lending (Figure 2.5) in particular has received great emphasis from academics seeking to comprehend how microfinance deals with information, enforcement and administrative costs (Honohan 2005, p. 15). For instance, Armendáriz & Morduch (2005, chap. 4) argue that group-lending-based contracts provide, in principle, efficient outcomes through the promotion of social capital, and that without collateral. Moreover, group lending mitigates problems created by adverse selection (Morduch, 1999) and “ensures low default rates and replaces standard collateral? (Dieckmann, 2007, p. 4).

Figure 2.5: Process of group-lending-based contracts

Source: Dieckmann (2007)

Other features differentiate MFIs from mainstream institutions in regards to the style of operation: the progressive increase in the amount borrowed from an individual or group members as each successive loan is repaid, the use of non-traditional collaterals (e.g. T.V.) and the high frequency of required repayment installments (Honohan, 2005, p. 16).

Subsidy may benefit a large portion of MFIs, whether in the form of technical support, a donation of capital not expected to be compensated, or a flow of funds provided at below market rates. Overall, MFIs remain heavily grant and subsidy dependent (Honohan, 2005). The subsidy feature through donation is developed in the next section considering the source of funding of MFIs.

2.3 Microfinance funding environment

At the present time, microfinance is not anymore considered as an isolated marginal sector that needs to be served only by niche market MFIs. Microfinance is becoming an integrated segment of the broader financial system. The example of the Mexican MFI Compartamos depicts well this evolution when, in April 2007, Compartamos sold 30% of its shares in an initial public offering (IPO) [1] that was oversubscribed 13 times and netted approximately US$467 million for the original investors (Daley-Harris, 2009). The success of the Compartamos IPO might no doubt facilitate future funding of MFIs, and improve microfinance image, particularly in regards to cross-border investors (CGAP, 2007).

2.3.1 Sources of funding for microfinance institutions: an overview

The availability of capital is key factor of growth for an MFI (Krauss & al., 2007, p.3). In order to supply microfinance borrowers with its services, an MFI needs capital on the liability side of its balance sheet. The funding process works basically like a mainstream financial institution. An MFI is financed either with equity, debt capital, or a mix of both capital structures. The equilibrium between debt and equity financing is key to the development and growth of an MFI (Maisch & al. 2006). Appendix II provides the pros and cons of each capital structure.

From the perspective of a microfinance investor, an MFI with a high growth potential over the next 3-5 years and with a strong gross margin to maintain its cash flow represents a serious equity investment candidate. MFIs that do not match the aforementioned criteria may still be potential equity investment candidates, although “with an investment structured to have lower risk?. (Maisch & al. 2006, p. 80).

Latin American MFIs have to a large extent a diversified source of funding. Based on a sample of 42 MFIs from Latin America and Caribbean region as of June 2008, MicroRate (2009, p. 30) finds that domestic sources -including deposits, local commercial loans and others domestic debt capital sources- make up 59% of funding of MFIs. Equity, coming from both domestic and international sources, accounts for another 30%. International sources of funding through debt account for the remaining part (11%).

Globally, Cull & al. (2008) find that microfinance banks (the more formalized institutions) rely predominantly on commercial funding and deposits. NGOs (app. 40% of the sample) rely mainly on donations and non-commercial borrowing. Credit unions (member-based financial institution) rely predominantly on deposits provided by their own members.

Table 2.2: Shares of total funding by institutional type (2005-2007)

Donations

Non-commercial

borrowing

Equity

Commercial

borrowing

Deposits

Bank

2%

1%

13%

13%

71%

Credit Union

11%

3%

16%

6%

64%

NBFI

23%

11%

18%

28%

21%

NGO

39%

16%

8%

26%

10%

Total

26%

11%

13%

23%

27%

Source: own representation based on Cull & al. (2008)

2.3.2 Degree of commercialization and issues

The funding situation of an MFI is associated with its degree of commercialization. Commercialization refers to a transition from a state of heavily donor-dependency of subsidized operations into one in which MFIs are financially self-sufficient and sustainable, and are part of the formal financial system (Ledgerwood & al. 2006). A classification of MFIs (Figure 2.5) according to their degree of commercialization depicts the growing disparity that reigns amongst MFIs. Meehan (2004, p. 7) states, “a growing divide is emerging between larger more commercially oriented specialized MFIs, many of whom are, or intend to become, regulated financial intermediaries, and smaller, NGO-managed MFIs?.

Figure 2.5: Types of MFIs according to their degree of commercialization

Source: Dieckmann (2007) based on Meehan (2004)

Tier 1 MFIs are developing into formal financial institutions, and are increasingly attracting the attention of private and institutional investors. Typically, tier 1 MFIs are profitable, have a more experienced management team, and are regulated institutions. On the contrary, tier 2 MFIs are smaller and less mature MFIs. According to Dieckmann (2007), these institutions are predominantly NGOs that are in the process of transforming into regulated MFIs. Tier 2 MFIs may receive funding from public or institutional investors, but less than Tier 1 MFIs. Tier 3 MFIs are predominantly NGOs as well. These institutions are close to becoming profitable MFIs, but are characterized by a lack of sufficient funding. Lastly, tier 4 MFIs are start-ups or informal financial institutions for whom microfinance is not their primary focus Dieckmann (2007).

Consequently, MFIs have an incentive to upgrade their institutional and regulatory status (e.g. from tier 2 to tier 1) in order to access more capital. This need for commercialization of MFIs, other than the increase in their depth of outreach [1] , is prompted by an endeavor for growth. Looking from a socially-motivated international investor viewpoint, some remarks have to be mentioned at this point.

First, an issue that can arise from this search of financial expansion through commercialization is a phenomenon called mission drift. It captures the process whereby an MFI departs from its social mission, and increasingly focuses on its financial performance. Mission drift occurs as an MFI might find profitable to reach out to wealthier clients while crowding out poorer clients. The risk of mission drift is more likely when an MFI “transforms into a formal institution or when shareholders are changing? (Lapenu & Pierret, 2005, p. 67). As such, the commercialization of an MFI is expected to harm its social performance, consequently deteriorate the dual return that foreign institutional investors expect to achieve from the financial and social performance of the MFI invested in (Mersland & Strøm, 2009). From a policy standpoint, Armendáriz & Szafarz (2009) emphasize that “donors and socially responsible investors can be easily mislead by MFIs which are serving unbanked wealthier populations?.

Second, MFI growth can be sustainable and reflect financial strength, but uncontrolled growth can be hazardous for an MFI. It can lead to increased delinquency and, in the long-term, problems that can even result in an MFI bankruptcy (Lapenu & Pierret, 2005). This issue of uncontrolled growth is reflected in recent delinquency crises in Nicaragua, Morocco, Bosnia and Herzegovina, and Pakistan (CGAP, 2010b). This later point is extensively enhanced in Section 5.3.

In addition, Fitch Ratings (2008, p. 17) notes a challenge faced particularly by tier 1 and 2 MFIs. As an MFI transforms and commercializes, and as microfinance borrowers are becoming integrated into the mainstream financial system, a risk can occur that “the resulting convergence between microfinance and mainstream banking effectively strips microfinance of the very characteristics that help to insulate it to some extent from wider economic trends?.

International funding of microfinance

This chapter provides a topology of international key actors funding microfinance. Furthermore, it aims to depict how flows of cross-border funding reach MFIs. The microfinance area lacks at the present time of a clear and exhaustive categorization of funders, channels of funding, financial instruments etc. This is due to the relative immaturity and constant evolution of microfinance, and an actual search of consensus among CGAP, leading asset managers and industry experts. Therefore, the present chapter is structured to situate microfinance investment vehicles in a clarified microfinance landscape.

3.1 Primary cross-border funders

The landscape of primary cross-border funders [1] in microfinance is categorized by two groups: donors and investors. Table 3.1 provides a comprehensive classification.

Table 3.1: Landscape of primary cross-border funders

Source: adapted from cgap.org and CGAP (2009a)

Developing and transition economies receive international funding for microfinance. Traditionally, MFIs have been funded mainly from international financial institutions (IFIs) and donors. Donors may get involved in MFIs through a wide range of instruments; policy support, technical assistance, grants, loans [3] , equity investments in MFIs that can sell shares, and guarantees. For donors, direct funding of MFIs might be the most effective channel (CGAP, 2006, p. 95). However, many donors, particularly multilateral development banks, work only with governments, typically providing them with soft loans. The latter might be suitable for funding traditional aid activities (e.g. building roads, hospitals, and schools), but less appropriate for supporting MFIs development (CGAP, 2006).

Furthermore, there is recognition that neither IFIs nor donors (e.g. NGOs) have been successful in delivering sustainable services to significant numbers of MFIs. A shift in direct cross-border funding is occurring; institutional and (for-profit) individual investors are progressively filling this role of sustainable investor (Berger & al. 2006).

Besides, microfinance is increasingly recognized as an (emerging) asset class among global private investors. Microfinance investments offer a double-line return – a financial and a social one. In addition, investing in microfinance may provide portfolio diversification value for international investors (Krauss & Walter, 2008). Currently, domestic sources of funding, including deposits, account for 85% of microfinance funding, while foreign sources account for 15% (CGAP, 2010).

In 2008, microfinance funders (i.e. donors and investors) disbursed US$3 billion and increased their commitments by 24%, reaching US$14.8 billion committed as of December 2008 (CGAP, 2009a). Investors account approximately for two-third of the commitment, while donors complete the rest of the aforementioned amount. Despite the financial crisis funding projections for 2009, reported by a majority of funders, have not been affected (CGAP, 2009a) [2] in 2005 to 29% in 2008.

Figure 3.1: Microfinance investment growth by investor type

Source: own research, adapted from CGAP (2009b) and cgap.org

Institutional investment is mainly composed by 13 commercial banks (aggregate assets of US$ 797m), 6 pension funds (aggregate assets of US$ 681m) and 5 private equity firms focusing on investments in India (CGAP, 2009b). Commercial banks have been around the longest, essentially the European ones. Pension funds like Tiaa Cref have been important investors. Private Equity Investors have been higher profile in recent years, many of them solely focused on financial gains especially with pre-IPO candidates, principally in India. The SKS deal in 2007 was a key spur to their interest. Niche players like Legatum and Sequoia are now being followed by heavyweights as Blackstone, general Atlantic, TPG and Carlyle. Many now proclaim that these investors are interested in mf as a sector, or asset class. I have my doubts, many have only invested in 1 or 2 token deals. I suspect their interest is in the Indian market, as a huge and rapidly growing, untapped markets. Endowments: Tufts with Omidyar funding has led the way, but perhaps there could be others even though most endowments are focused on maximizing return. We know of only one Sovereign Wealth Funds, Temasek, invested in mf, but more may follow.