The Loan Rangers Eye the Capital Markets
by Nina Mehta, Contributing Editor, FENews http://www.fenews.com/fen40/inside_black_box/black_box.html Long, long ago, in 1976, an economics professor in Bangladesh dispensed a total of $27 in small loans to 42 impoverished people caught in the clutches of moneylenders. As banks refused to loan money to poor people, Muhammad Yunus continued lending, was repaid, and in 1983 formed Grameen Bank. Since then the bank has disbursed $4.3 billion in microloans to people too poor, remote, or uncollateralized for traditional banks. Impressed by the now legendary success of the Bangladeshi professor who trained as an economist at Vanderbilt University, other groups and institutions got into the game, adapting his model of lending to the needs of the poor and unbanked in other parts of the world. Yunus didnt invent the field of microfinance. Social cooperatives, credit unions, and other forms of collective lending already existed. But he helped change the goal of what is now known as microfinance. The goal became to help reduce poverty by providing credit and other financial services to the poor, and to do so commercially -- that is, at a profit -- so that the overall enterprise could be financially sustainable. Microfinance initially revolved around the extension of credit to the self-employed poor. But the poor, like the rich and the middling well-off, also need access to savings, insurance, money-transfer facilities and long-term housing loans. So while microfinance currently means a $100 loan to a Croatian seamstress so she can expand her business, or a $350 loan and a savings account for a Bolivian couple starting a roadside restaurant, it could -- eventually -- include crop insurance for a migrant sorghum farmer in Burkino Faso. What does all this mean for Wall Street? At the moment, not much. But that may not be true in five or 10 years. Investments in microfinance can generate handsome, reliable returns for patient money, says Martin Holtmann, a lead microfinance specialist at the Consultative Group to Assist the Poor, a consortium of 28 multilateral development agencies and foundations thats housed in the World Bank. This is an important and pretty professional business, with great assets behind it, he adds. The microfinance industry took off in the 1980s and 90s as people saw that the self-employed poor repaid their loans at rates that would give a commercial loan officer pause. Repayment rates of 97 percent or 98 percent were not unusual. But as the industry has grown, cracks have appeared. The high repayment rate hasnt always been what it seemed since some microfinance institutions, or MFIs, rolled over delinquent loans rather than writing them down. Many informal, badly run MFIs that failed to manage their portfolios have drifted out of existence. However, this isnt alarming in an emerging industry -- or emerging asset class, as some call the microfinance industry. On the contrary, efforts to highlight inefficiencies are now encouraging new and better credit scoring techniques and loan-loss provisioning. There is also a movement toward more rigorous international accounting standards for commercial MFIs and a gradual shift toward more reliable performance metrics. Another reason Wall Street may well eventually take an interest in microfinance is that returns from microloans are uncorrelated with returns from other asset classes. In June 1998, at the height of Indonesias banking crisis, for instance, nonperforming loans represented up to 60 percent of the total loan portfolio in Indonesias banking sector, while the portfolio at risk was under 6 percent at Bank Rakyat Indonesia. BRI is the worlds largest MFI, with 3.1 million active microborrowers and a gross loan portfolio of $1.7 billion. MFIs in other countries have shown similar resilience in the face of events that impact mainstream loan portfolios more severely. Microfinance is also likely to take root for other reasons. Regional retail banks can expand their customer base through microloans. Those being mainstreamed into the financial system through small loans and the provision of savings accounts will in three, five or 20 years from now require more -- not fewer -- financial services. For some retail banks, bringing poor clients into the fold can be a low-cost way of building brand loyalty. Interest in microfinance is also bubbling up in business schools in Costa Rica, the Philippines and South Africa. Meanwhile, graduate students at Columbia University, the University of Michigan, UCLA, and the Wharton School are forming microfinance clubs to explore issues and challenges within the industry, says Leslie Barcus, president of the Microfinance Management Institute, formed in 2003 by the Open Society Institute and CGAP. In recent years the goal of the larger and more long-term microfinance players has been clear, if not always simple: to move the industry away from donor funds and toward commercial funds, to make MFIs more efficient and transparent, and to help MFIs access local capital markets in order to leverage their funds. On a more macro level, the purpose of the effort is to lower the hem of the banking industry so that it covers a larger portion of the approximately six billion unbanked individuals around the world, whose lower echelons include the poor and the very poor -- the target audience of most MFIs. To do this, MFIs must reach for more commercial sources of funding and become more mainstream, regulated entities. This is starting to happen. Many nongovernmental organizations that have expanded their balance sheets and become self-sustaining have moved away from their donor-funded origins and transitioned into banks or some form of regulated financial institution. This is particularly true in Latin America, where MFIs on average have been around longer and where the microfinance market is more developed than in, say, Asia or Africa. Perus Mibanco, which began life as an NGO, became a private commercial bank in 1998. Financiera Compartamos, founded in 1990 as an NGO in Mexico, became a finance company three years ago. Bolivias PRODEM, formerly a nonprofit MFI, reconstituted itself in 1999 as a regulated private financial fund. According to CGAP, probably no more than 2 percent of the 10,000 largest MFIs are financially self-sufficient and do not rely on donor funds and subsidies to operate. While that number isn't large, those institutions serve the majority of microfinance clients around the world. One obstacle to the development of the industry is the donor money that has fueled the fields growth thus far. Simply put, donor money is inefficient. Its hard to go to the capital markets when your competitors are getting money for free, says David Satterthwaite, CEO of Prisma Microfinance, a U.S. private equity firm founded in 2000 that is active in Nicaragua and Honduras. The industry, say many within it, must be judged on commercial terms for it to succeed. A related impediment is the presence of state-owned banks with a history of operating on a subsidized basis. These banks, like donor money that does not punish inefficiency, often drive out commercial players. Countries with state-owned banks that operate inefficiently, subsidize loans and lend on a political basis have somewhat retarded the development of the field, says Elisabeth Rhyne, head of the research and policy department of ACCION International. ACCION, a non-profit organization with a $1.2 billion loan portfolio that supports MFIs in Latin America, the Caribbean and Africa, has led the way in strengthening the business of microfinance and encouraging the commercialization of the field. To grow as an industry, MFIs must take advantage of economies of scale. All the numbers show that as your portfolio grows, your efficiency goes up -- and your operating costs per dollar lent decrease, says CGAPs Holtmann. As lending margins come down, there is huge pressure to consolidate. After much talk, this is finally beginning to happen. The most significant recent event is the emergence of a network of banks under one banner: ProCredit Bank. Eighteen banks in Eastern Europe and Central Asia, Latin America, and Africa are being gathered into a microfinance banking network with uniform assessment processes and standards. The ProCredit network is spearheaded by Internationale Micro Investitionen AG, an investment company known as IMI and formed by German consulting group IPC and its members. IMI typically takes a majority equity stake in each bank. The combined loan portfolio of ProCredit banks, currently EUR 813 million, is expected to rise to EUR 2.7 billion by 2008. Many in the industry applaud IMIs consolidation efforts and say that the development of a transnational network of microfinance banks will lead to greater transparency and efficiency. Across the board, MFIs seeking to increase the size of their loan portfolios are looking for larger and more diverse funding sources. Although the vast majority of money in the microfinance industry comes from multilateral development banks and other donors, the number of commercial equity and debt funds, for instance, is growing. Dexia Micro-Credit Fund, created in 1998 by Dexia Banque Interntionale a Luxembourg, was the first commercial investment fund designed to finance microfinance institutions. The fund started with $10 million and now has a net asset value of $45.5 million. Through early January of this year, the fund had produced a cumulative net return of 27.4 percent. An industry web site, www.mixmarket.org, lists about 25 commercial investment funds active in microfinance. If microfinance can commercialize and float real securities -- and its a long, long way from that -- the benefit could be massive, says Satterthwaite. Would you check off a box on your 401(k) form for a fund with an average return of 10 percent? he asks. Thats the vision, he continues. The goal now is to educate financial professionals about microfinance as an emerging asset class. But barriers exist. One current obstacle for equity investors is the governance structure of many unregulated MFIs. Many have weak governance, weak internal controls, and informal management structures. Often theyre also not set up legally to accept equity. The structure of NGOs and informal MFIs can also make accessing the capital markets difficult. Commercial banks that dont understand the legal status of MFIs are reluctant to lend to them. They dont know who theyd go after if the loan is not performing, says Patricia Mwangi, a microfinance specialist at CGAP and manager of the Microfinance Rating and Assessment Fund, which promotes financial transparency and more rigorous performance standards among MFIs. Banks are not comfortable taking guarantees from people who do not have an equity stake in the firm. However, these issues are likely to be addressed as firms become more profitable and rethink their structure. As a secondary market in microfinance debt develops, some see a future for asset-backed securitizations of microfinance loans. There have been shufflings in this direction, but scant activity. One problem is the lack of sufficient high-quality loans that can be aggregated into a deal of significant size. For subordinated debt offerings, there is also reluctance among investors to take the first-loss piece. That means credit enhancement facilities are necessary -- or donors prepared to take on the riskiest tranche. Last July, Geneva-based BlueOrchard Finance and Developing World Markets, a socially responsible investment firm in Darien, Conn., issued the first U.S. dollar-denominated microfinance bonds. To attract risk-averse institutional investors to its seven-year $40 million subordinated debt issue, the funds got a $30 million credit guarantee from the Overseas Private Investment Corp., a U.S. development agency. The senior notes, backed by the OPIC-guaranteed funds, yield 55 basis points over Treasuries, while three junior tranches offer between 100 and 500 basis points over Treasuries. The riskiest equity piece is held by the sponsors. Proceeds from the bond offering are expected to help about 40,000 microentrepreneurs in Latin America, Asia, Africa and Eastern Europe. More MFIs, however, are looking toward local debt markets to lower their financing costs. Take Compartamos, the largest microfinance lender in the Americas, with 240,000 microentrepreneurs on its books, 95 percent of them women in poor rural areas. To raise capital from Mexican pension funds, mutual funds and other institutional investors, Compartamos worked with Citigroup and Banamex and last August issued $44 million worth of five-year bonds, which were rated AA by the local affiliates of Standard & Poors and Fitch Ratings. The high rating was a microfinance first. The International Finance Corp., the private sector arm of the World Bank, provided a 34 percent loan guarantee. A big concern with raising money from foreign capital markets is the foreign exchange risk. Its not the Californian but the Kenyan pension fund that a local MFI in Kenya needs to access, notes CGAPs Holtmann. What good does it do if a Wall Street banker comes along and offers a $50 million convertible loan or straight loan if, at the end of the day, you carry huge foreign exchange risk? Theres no effective and low-cost way to hedge that risk in many of the countries with microlending needs. Holtmann adds that financial engineering solutions may yet develop, but at the moment, foreign exchange risk in balance sheets is a prospect that scares away other potential investors. (BlueOrchard dealt with this issue by lending primarily to MFIs in dollarized economies.) With MFIs eyeing more commercial funding sources, national regulatory policies that inhibit the development of MFIs are coming under scrutiny. Prudential regulation is necessary -- and desirable -- for MFIs expanding the services they offer, say industry professionals. However, existing regulations can prevent growing MFIs from operating efficiently. Over the years, a regulatory wall that many MFIs have run up against is a cap on interest rates charged on loans. MFIs must charge high interest rates to cover their costs, which are higher than those associated with providing more traditional loans to clients with collateral. Annual interest rates for microfinance loans can easily be 15 percent or even 30 percent. In Colombia, for instance, NGOs are free to charge any interest rate, but regulated financial institutions cannot. That creates a disincentive for a microfinance NGO to become a commercial financial institution, says ACCIONs Rhyne. Some countries, including Ghana, Bolivia, Indonesia, and South Africa have microfinance-specific legislation, but the practical needs of MFIs may or may not be balanced with the goal of financial soundness. In South Africa, MFIs that are not banks are lightly regulated as long as they fall under an exemption to the Usury Act, but a labyrinth of regulations constrain their operations. Governments intent on promoting microfinance have taken different paths. In Latin America, where the industry is more developed, Bolivia and Chile offer two successful but different regulatory models, according to Rhyne. In 1995 the Bolivian government, which has taken a neoliberal, laissez-faire approach to the financial markets, promoted the commercialization of microfinance institutions by creating a separate category of institutions that are rigorously supervised but have lower minimum capital requirements than other financial institutions. For these FFPs, or private financial funds, the minimum capital requirement increases as the financial institution grows. The government was very responsive to the needs of MFIs when it created this legislative category, says Rhyne. Most of Bolivias big microfinance providers -- with the exception of BancoSol, a regulated bank supervised under the general banking law -- fall into this category. Chile took a different route. In 1992 the government provided incentives to commercial banks to make microloans to the uncollateralized poor -- essentially, to downscale their activities. The incentive was structured as a quasi interest rate subsidy to defray the high cost of servicing this new client base. Over time the subsidy decreases. This was aimed at helping institutions get into the field, but not subsidizing their long-term presence, says Rhyne. It was a smart use of subsidies by a government. In addition to policy changes, the commercialization of MFIs increasingly depends on outside vetting by rating agencies. This is happening, but in slow motion. The largest commercial raters -- Standard and Poors, Moodys, and Fitch Ratings -- are only marginally involved in the microfinance industry. >From the perspective of these raters, the main issue is the volume of institutions that are ready to be rated, says ACCIONs Rhyne. Its not large. For MFIs, on the other hand, a big concern is pricing, since maintaining a rating from, say S&P, can be costly. An MFI or commercial fund issuing bonds would have to go into the capital markets on a regular basis to justify the cost. In the meantime, the growth of the microfinance industry has given rise to an interesting new breed of rater: specialized microfinance rating agencies such as MicroRate, PlaNet Finance, CRISIL, M-CRIL, and Microfinanza -- many focusing on geographic regions. These raters, which over the last decade developed their own risk methodologies geared toward the MFIs they assess, typically enable donors to judge the quality of MFI loan portfolios and the stability of the organizations themselves. The Rating Fund, formed in 2001 by the Inter-American Development Bank and CGAP, works with specialized and international raters on MFI risk and return assessment, says Mwangi, the funds manager. The fund also helps MFIs purchase independent rating and assessment services; to date it has helped pay for more than 180 ratings and assessments. However, if the industry is to get a seat at the table of local or international capital markets, overtures must increasingly be made to investors and commercial funding sources, rather than donors. For traditional investors not aware that this market can be profitable and reliable, ratings from the largest commercial rating agencies can quantify the risks associated with investing in microfinance bonds. Specialized raters are useful for donors and social investors, but many dont have mainstream credit products an institution would use for issuing debt, says Mwangi. International raters such as Standard & Poors and Fitch appeal to investors because the raters use their standard grade systems, which are already well-known. According to Mwangi, Moodys has been less involved in rating institutions that work in microfinance, although Moodys Singapore is about to rate an MFI. The current hitch with these raters is that they dont fully understand the operations of MFIs. And MFI managers, for their part, are more comfortable working with specialized microfinance rating agencies that understand the nature of their operations. To an international rater, an MFIs processes can seem informal. Critical things like internal controls are different, notes Mwangi. If S&P, for instance, is looking for traditional internal controls, they wont find them. Specialized raters rely on alternative internal controls, just as MFIs turn to alternative ways of gauging the likelihood of an individual repaying a loan, rather than relying on collateral. Do the alternative internal controls work? We believe theyre reliable, but we cant prove beyond a shadow of a doubt that, yes, theyre reliable enough for S&P to assure investors that the governance controls are fine, says Mwangi. Finding a balance between the approach that international rating agencies apply and the realities of MFIs is hugely important to the microfinance industry -- but it is a work in progress. A goal across the microfinance industry is to be able to measure and evaluate the risks associated with investing in MFIs or microcredit-based instruments. As that happens, investors can compare portfolios and take on the risks they want, thus increasing the flow of efficient money into the system. According to CGAPs Holtmann, this means that international commercial raters must understand that a microfinance bank is a different animal than a traditional bank that invests in bricks and mortar, but one that can nonetheless be quantified. Other than that, theres nothing about microfinance thats so spectacularly different from the rest of the financial system, he says. At CGAP we predict that even the word microfinance is poised to disappear eventually since this is just part of the big financial system. 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