Keeping its eyes on the ball: microfinance tackles issues rising from its success
Luxembourg has established its voice in the microfinance industry: in the words of Tom Seale, Vice-Chairman of ALFI, the Grand Duchy helps to “put the finance into microfinance”. This puts Luxembourg in the front line of accusations that the microfinance industry has been a victim of its own success. The focus of a recent one-day conference was on two questions: is commercial pressure creating mission drift? And, how do you measure social performance of microfinance investment funds?
The delegates gathered in Luxembourg shared two fundamental attitudes: belief in microfinance as a tool to alleviate poverty and in the fact that it cannot achieve scale and financial sustainability without commercial backing. Indeed, both commercial banks and private individuals have been pouring money into microfinance. However, like any fast growing commercial activity in a free market, this attracts a spectrum of outcomes; these need to be monitored and the incentives adjusted where necessary.
The conference, which was opened by Luxembourg Minister of Finance Luc Frieden, tackled these issues head on.
The good news …
Damian von Stauffenberg, director of the rating agency Microrate, explained that prior to the economic crisis the microfinance industry had experienced ten years with a compound annual growth rate of 40%, which put enormous strain on management. However, though it was “too early to declare victory”, the industry had come well out of the financial crisis. Microfinance institutions (MFIs) had received the message early in 2008 and reacted instantly, slowing growth and raising reserves. As a result, most were still profitable.
He sees five trends in the industry.
- The most mature MFIs have grown with their clients and are now offering small business loans. This is not “mission drift”, but a sign of success.
- There is a steady increase in the sophistication of management, often assisted by technical assistance programmes.
- There is a trend towards formalisation. Successful donor-funded MFIs that started out as NGOs run into the problem that they can only lend out 3x their assets. This leads them to adopt a formal structure in order to access commercial capital.
- Balance sheets are strong: loan loss provisions often exceed all outstanding loans over 30 days by over 100%.
- MFIs are conscious of forex risk, using exotic currency swaps where available and special facilities such as the Dutch MFX. The EIB is launching its own facility, SIGMA.
… and the concerns
There are two major concerns. The first is that too much money is chasing too few MFIs. Most microfinance investment vehicles (MIVs) invest in the same 2-300 “tier 1” MFIs that are sophisticated enough to deal with the capital markets. As a result, yields are falling and lending rates are below the level where they cover the price of risk. Meanwhile, the inability to find suitable investment targets has led funds to carry a high level of liquidity which is dragging on performance.
Secondly, because so much money needs to be absorbed, the definition of “microfinance” has been allowed to expand and in von Stauffenberg’s opinion this trend has gone too far, to include insurance, educational loans and consumer credit. The foundation of the business, he argues, is to give out working capital on a tiny scale. “Microfinance must be linked to the creation of wealth. This is the vision that powers the industry. A loan that leaves the borrower poorer is not good.” He goes on to add that small business lending is necessary, but that “the risk characteristics are different from microfinance. They stand up less well in stressful times”; a fact that was illustrated recently when microfinance in Eastern Europe – typically small business loans - stood up less well to the financial crisis.
Jasmina Glisovic, speaking for CGAP at theWorld Bank, which strives to set norms for the industry, disagrees with the last point. She argues that although micro-credit is the heart of the industry, microfinance is about “financial inclusion” and has to provide other services.
Mission drift or growing pains?
Throughout the day speakers returned to the question of mission drift and clearly there are MFIs that have behaved unethically, lending to indebted clients and bullying debtors. But for the most part the industry is holding up well under extraordinary growth pressure. Some criticisms need to be set in context: what appear to be outrageously high interest rates may be explained by average loan sizes of USD 100 and should be compared to other rates available in the same market.
One problem is the ballooning growth of MIVs. Fund managers, unable to place their money, put pressure on MFIs to accept larger loans than they asked for, or can healthily place, leading to a fall in the quality of business. Competition from public investors is also exacerbating concentration in the tier 1 space.
Another factor is that in the last ten years the focus has moved away from family viability to MFI viability. A more commercial focus has been the inevitable result of the professionalisation of MFI management teams. This can lead in two undesirable directions: one is that MFIs start to offer larger loans to fewer people, because this is more profitable; the other is that in order to increase business MFIs start to sell products that do not improve the financial position of the family, but make them poorer. Such an outcome is clearly mission drift.
The way forward
The solution put forward is for different players to focus on their true roles. There will always be a need for donor money and its role should be to finance green field sites. This will typically be followed by private equity funding projects that still carry a high risk of failure. At this stage there is a continuous focus on training, which may be funded by donor financial institutions (DFIs).
The final stage is when an MFI is ready to accept loans funded by retail investment vehicles. However, at present the tier 1 market cannot absorb any more of this and managers like responsAbility have stopped fund raising in these vehicles. Triodos, for the same reason, is fundraising for green field start-ups in new countries. The important thing, says Femke Bos of Triodos, is to be transparent when dealing with investors.
Meanwhile, some DFIs are coming up with the money and the innovative solutions that answer these complex questions, for instance, by layering the risk and the reward for different tranches of investors. This helps expand the investible market down into tier 2 and tier 3 MFIs, by subsidising the risk. What is more, DFIs have strongly defined social goals and this puts pressure on MFI managers to stay on mission.
Finally, there is a need for more and better data in the industry, such as risk adjustment by market and by MFI. There must be segmentation of microfinance consumers: which products for which people? Luxembourg, as a financial centre, has a role to play here.
The other burning question of the day was how to measure the social performance of investment funds.
“Social performance cannot be taken for granted” said Axel de Ville of ADA. While ADA and other fund managers are all tackling the challenge, nobody claims to have solved it. Triodos has appointed a Social Performance Task Force. Incofin asks MFIs to complete a detailed social performance questionnaire, but admits it is measuring the performance of the MFI, not the social impact of the loans.
Progress has been made at the MFI level, where the number of social ratings has risen sharply from around 20 two years ago, when such ratings started, to some 100 anticipated this year. Yet even this raises difficult questions. Who pays? Who will develop the software tools? And it is a long-term project: it takes at least five years to establish a fair “track record”. Yet, as Axel de Ville pointed out, MFIs cannot be expected to improve if they do not know where they are.
Another important factor mentioned by all the fund managers is to ensure that you only accept investors with the right attitude. Preparatory work done on motivation was very important in keeping investors during the financial crisis, explained Geert Roosen of BlueOrchard.
At the investment fund level, until now, it has been up to individual fund managers to choose whether, and how much, to report on social performance. The big retail funds make a considerable effort to achieve transparency in this area and the trend is building momentum: the microfinance fund labelling agency, LuxFLAG, has recently added social performance criteria to its requirements for any fund that wants to be awarded the coveted “LuxFLAG Microfinance Fund” label.
However, the proof of the pudding is in the eating. Delegates were left with a hard fact to chew on: that unless social indicators are seen to be used by asset allocators, the MFI industry will not take them seriously.