Since the advent of the global economic downturn in mid-2007, there has been much discussion regarding what impact, if any, the financial crisis will have on the microfinance sector.  Yana Watson of Dalberg Global Development Advisors provides a diagnosis of different impacts on MFIs depending on their capital structure and geography.  She contends that while the impact of the crisis can be anticipated, its outcome is not a foregone conclusion.  For microfinance to survive and thrive, she shares recommendations for action on the part of microfinance network and institution leaders, as well as public and private investors. 

It is only the first quarter of 2009 and it is unclear whether we have seen the entire iceberg of this financial crisis, or merely the tip.  Whatever the ultimate scale and scope of the crisis, it seems unlikely that the microfinance sector will emerge entirely unscathed.  That said, the impact of the crisis is far from a foregone conclusion.  With the right strategies, microfinance institution (MFI) managers and capital providers can survive, and even find means to thrive, despite the global recession.

Why this time is different

Some believe that microfinance is immune to the current meltdown of financial markets, citing its resilience to crises in the 1990s and claiming that balance sheets in the sector are impervious to adverse external economic shocks.  But one cannot escape the reality that today’s microfinance is more closely tied to international capital markets or that this crisis seems unique in both scope and scale. Therefore, it is difficult to ascribe wisdom or rationality to any conclusion that forecasts with certainty a positive outcome for MFIs. 

History is not necessarily a guide for predicting the outcome of this crisis since microfinance is no longer the uncorrelated market that it was during the downturns of the 1990s.  During that period, only a handful of MFIs had even begun to contemplate transforming into regulated deposit-taking banks with access to commercial funding sources.  But by the early 2000s -- with Banco Compartamos’ bond issuance; Bank Rakyat Indonesia’s first microfinance IPO; and the emergence of microfinance collateralized debt obligations (CDOs) -- microfinance had burst onto the international capital market. With the United Nations naming 2005 as the Year of Microcredit and Prof. Mohammad Yunus receiving the Nobel Peace Prize for the work of Grameen Bank, microfinance seemed to emerge as the darling of international development. By 2007, an estimated US$5b of foreign investment1 had flowed from developed nations into MFIs around the world. 

As a result, today microfinance is tied to global markets to an unprecedented degree.  Unfortunately, those markets are simultaneously experiencing a near-unprecedented degree of turmoil that seems to combine the worst characteristics of downturns in the 1990s.    If we look to the Asian crisis, the more widespread of the past proxies available for academic study, we should take note that microfinance suffered most where it was most tied to the formal financial system.  In Indonesia, the value of Bank Rakyat Indonesia’s Unit Desa fell by one-quarter to one-half in constant price terms.2 The current downturn shows signs of being both more severe and more all-encompassing than prior crises.  Global trade this year is projected to contract for the first time since 1982.  Both GDP growth in developing countries and private capital flows to developing countries are projected to fall to roughly half their 2007 levels. With reductions in foreign investment and remittance flows, increases in country risk premiums and local credit spreads, there does not appear to be any safe haven.  

The critical dimensions of country and capital

According to estimates for 2007,   there are roughly 10,000 MFIs with a collective asset base of more than US$35bn, serving 66 million clients across the globe.3 MFIs come in all shapes and sizes, with different institutional types, missions, and lending methodologies, in different socio-political settings, and subject to different legal and regulatory frameworks.  A meaningful diagnosis of the impact of the financial crisis on MFIs requires a segmentation of the sector by the most critical defining dimensions.  

The sector should be segmented according to the characteristics that are most influential in determining an MFI’s experience during the crisis: country location and capital structure. Country location is a critical factor due to the formative influences of an MFI’s economic and regulatory operating environment.  Government can either alleviate or exacerbate the impacts of the financial crisis through central bank lending policies, fiscal stimulus measures, and monetary policies.   While there is insufficient space to allow for a full geographic segmentation of MFIs, the following examples highlight the importance of country-specific impact analysis.

East Asia and the Pacific:

In response to liquidity tightening, Korea’s financial regulator deferred implementation of the Basel II framework from January 2009 to 2010.4  This intervention was designed to keep capital requirements low and thereby ease liquidity.  In addition, the government announced it would provide $100 billion won or roughly US$73 million in direct loans and guarantees to micro and small business owners unable to otherwise secure financing during the economic downturn.5 Due to these activist measures, MFIs in Korea should experience relatively lower liquidity pains during the financial crisis. 

Eastern Europe and Central Asia:

Mongolia’s central bank recently decreed that commercial banks maintain minimum capital adequacy ratios of 12% -- a measure that was designed to safeguard customer deposits.6 However, while larger MFIs like XacBank have successfully met the new requirements, it is reasonable to expect that smaller, less well-established MFIs may find this challenging.  As such, surviving the credit crunch will likely require severely curtailed growth plans.

Latin America and the Caribbean:

In the early days of the crisis, liquidity issues arose in the region at an alarming rate.  Problems were compounded by the fact that the region lags in terms of deposit-taking, as only about 18% of microfinance-receiving families had a savings product at the end of 2006, versus 22% on average in Africa and 37% in Asia.7 Certain countries have taken action that may mitigate liquidity issues for MFIs.  In Colombia, the government has facilitated capital flows by removing restrictions on foreign lending and lowering interest rates.8

Middle East and North Africa:

As many MFIs in this region operate in highly regulated, insulated financial markets, we can expect less of an impact from the global financial crisis.9  In Tunisia, for example, Enda Inter-Arabe credits strict regulation and exchange controls with mitigating the impact of the crisis.

South Asia:

In India, initiatives to increase liquidity and lower foreign exchange risk have done much to ease the impact of the crisis on the microfinance sector.  The Central Bank lifted foreign lending restrictions to non-bank financial companies (many of which are MFIs), let the rupee depreciate to slow the outflow of capital, and is providing extra funding to the financial sector.10 Interviewees on both the institution and investment sides of the sector claimed the overall impact of the crisis on the subcontinent had been limited to date, in part to due to proactive government measures such as these. 

Sub-Saharan Africa:

In Kenya, a key concern of MFIs is repayment as the economy slows.  One MFI, Jamii Bora, has seen a rise in non-performing loans as clients are slipping back into deeper poverty levels due to lower profit margins from their microenterprises.   However, the implementation in May 2008 of the Kenyan Microfinance Act now enables regulated MFIs to accept client deposits.11  We can expect these deposit-taking MFIs to better withstand repayment volatility.

In conjunction with country location, capital structure is the second critical dimension for microfinance sector segmentation.  Liability mix will determine the type and degree of MFI risk exposure during the crisis, as different capital sources can be expected to react in distinct and predictable ways.

As shown in Figure 1: MFI Funding by Source, microfinance institutions derive capital from three main sources: debt, deposits, and equity.  Debt financing in microfinance far exceeds equity, driven by the creation of microfinance investment vehicles (MIVs) and structured debt instruments such as collateralized debt and loan obligations.  These instruments have been tailored to the microfinance sector offering first loss junior tranches at higher rates to the risk-leading development banks and safer senior positions with guaranteed returns to commercial investors.12 CGAP’s 2008 MIV survey concluded that there were roughly 90 MIVs with slightly more than US$5bn in assets under management investing in the sector by the end of 2007, representing a nearly 80% increase from 2006.13 Similarly, although equity accounts for a smaller overall slice of sector funding, it too has grown remarkably, given the limited exit options in microfinance and the general uncertainty that surrounds valuation techniques.  The potential of microfinance equity was perhaps most famously illustrated by the IPO of the Mexican MFI Banco Compartamos.   The IPO involved a secondary offering of 30% of Compartamos’ stock and raised roughly US$450m, yielding investors an IRR of over 100% compounded over 8 years.  The Compartamos issue was 13 times oversubscribed.14 Unsurprisingly, the Banana Skins report on types of risk in microfinance published by the Centre for the Study of Financial Innovation (CSFI) in 2007 concluded that capital availability was not a risk to the sector.  

Today, the times of free-flowing capital appear behind us.  As the financial crisis deepens, there is mounting evidence that capital flows are ebbing.  Women’s World Banking assembled a US$100m CDO for 14 members late in 2007, but according to CEO Mary Ellen Iskenderian, was unable to bring it to market due to risk aversion that was not commensurate with the underlying asset quality of the MFIs in question.15 Funding from public investors is also drying up as international financial institutions hit counterparty or country exposure risk ceilings.16 In today’s environment of local currency devaluation and rising repayment rates, lack of capital to manage volatility is a leading concern of most MFIs.   Although most MFIs are funded from a mix of sources, the effect of the financial crisis can nonetheless be reasonably anticipated by reflecting upon the primary source of MFI funding.

Deposit-based MFIs

MFIs that are highly reliant on deposits with relatively little third-party funding are in the lowest risk group.  The financial crisis should pose less of a threat to these institutions as they are more protected from refinancing and foreign exchange problems.  However, deposit-based MFIs will still challenged by inflation, food and fuel price volatility, and a decrease in remittance flows.17 As local currencies in developing countries lose value, clients will find it increasingly difficult to maintain savings levels.  Deposits may decline and non-performing loans may increase as clients require additional capital to cover basic needs.  

Debt-based MFIs

MFIs that depend upon fixed-income investment are at greatest risk during the financial crisis, particularly those with closer ties to international / commercial sources of funding versus local / public sources of funding.  In today’s economy, there is less available debt capital and it is offered at higher interest rates.  Foreign loans compound the problem by requiring repayment in hard currency at a moment of devalued domestic currencies.  Moreover, since local currency funds have suffered significant losses over the past year, they will be increasingly scarce going forward.  In the first quarter of 2008, only 30% of international investments were in local currency18, leaving MFIs to bear the foreign exchange risk.  While there are multiple options for hedging risk, ranging from countervailing foreign exchange deposits to futures and forwards, few MFIs have the institutional know-how or the domestic capital market sophistication to deploy these instruments to full effect.

Equity-based MFIs

MFIs that are reliant on equity investment will likely find themselves in the middle of the risk range.  Historically equity investors have been drawn to microfinance’s low default rates and strong profit margins.  As shown in Figure 2, MFIs enjoy higher net interest margins (NIMs) and lower PAR than commercial emerging market institutions.  The rising cost of funding precipitated by the financial crisis has begun to compress NIMs, and while some MFIs are passing a portion of these costs through to clients in the form of higher lending rates, many are not.19 If coupled with rising defaults and other expenses, this decrease in top line interest income would put pressure on profit margins and make microfinance less attractive to equity investors. To date, investor interviewees have not witnessed a spike in redemption calls.  However, new private equity investments appear to be slowing.  As MFI growth slows and earning power wanes, investors anticipate valuation multiples will slide from a median of 1.9x book value in 2008 to closer to 1x book in 2009.20  

Implications for action- MFIs

Given the likely impact of the financial crisis on the microfinance sector described above, the logical next question becomes: what can be done to navigate these circumstances as best possible?  Anticipating the likely impact of the financial crisis on the microfinance sector is only useful to the degree that it helps identify and prioritize mitigating actions.  As mentioned earlier, there are no foregone conclusions to this crisis.  How microfinance emerges will depend upon the actions of both MFI managers and capital providers.  For microfinance management, whether at the individual MFI level or the network level, there are three recommended actions for successfully navigating the financial crisis:

1.    Be ruthlessly demand-driven

Much of the published advice to date has focused on the importance of MFIs “sticking to the basics” of microcredit as a means to survive the financial downturn.   This may be good advice if credit reflects the demand-profile of clients, but it would be bad advice if that is not the case.    Ensuring that product portfolios are an accurate and recent reflection of customer needs, wants and preferences is always critical, but particularly so during times of financial volatility when there is little margin for error. 

The steps to determining demand begin with a segmentation of the MFI customer base.  Understanding customers along descriptive (Who?), behavioral (When? Where? How?) and attitudinal (Why?) dimensions will enable groupings according to shared attributes.  Representatives of those groups or segments can then be researched via a variety of means to determine wants, needs and preferences.  This customer data can then be mapped to products and services offered by the MFI. 

Questions to be considered include:

• Which products / services best reflect customer wants, needs and preferences? 
• Which products / services are not well aligned with wants, needs and preferences?
• Which wants, needs and preferences are not reflected in the product / service portfolio?
• Of the products / services in demand, which are we best suited to provide, given our capabilities and competencies?

2.    Shift from seeking scale to ensuring financial sustainability

Unsurprisingly in a sector that experienced a global median growth rate of roughly 20% in 2006-07 (reaching as high as 50%+ in some parts of Eastern Europe and Central Asia), the focus in microfinance in recent years has been on scale.21 MFI managers and network leaders have dedicated themselves to reaching a greater number of clients, across urban, peri-urban and rural regions, with a greater number of financial products and services.  However in a time of financial downturn, MFIs must temper growth aspirations and focus instead on economic sustainability. 

One part of sustainability relates to underlying portfolio quality.  Much of the sector advice lately has centered on the need for MFIs to actively monitor and manage portfolio quality.   Certainly, trends towards lower repayment rates and higher costs of funds make active management of an MFI’s underlying asset quality vital.  However, while necessary, this is not sufficient.  To ensure sustainability, an MFI must look hard at all the costs associated with providing products and services to different customer segments. 

In the section above, the MFI addressed questions designed to drive at true demand.  Building off these, further questions to pose to ensure economic sustainability include:

• Of the products / services that do satisfy demand, which are more / less financial viable?
• Of the various customer segments, which are the more / less costly to serve?
• How can the MFI streamline products and services to meet the demand of high-priority customer segments in an increasingly economically sustainable way?

Tactically, this might require cost analysis by product and customer type, overlaid on an analysis of the true total cost of doing business.  To illustrate, let’s take an example of a newly-regulated MFI that has been offering three savings products.  After having first established justifiable client demand for the provision of savings products (per the first recommended action above), the break-even cost curve would need to be determined and compared to the current cost curve for each product.   Backing out from the break-even point, managers can then assess whether the product profile or customer mix needs to be rebalanced (assuming different customer types bear different transaction costs due to differential transaction amounts, etc).  Since our example involves savings, the next step would also be to determine the benefit to the business of deposits from a cost-of-funds standpoint, as this is a critical component of total cost. 

3.    Consider consolidation

The financial crisis has put considerable strain on small and mid-sized MFIs’ ability to maintain operations.  Peer-to-peer institutional consolidation, although rare in the sector to date, offers one potential means of surviving the storm that warrants exploration. 

In the context of the credit crunch, the major benefits of consolidation are twofold.  First, consolidation can offer a resolution to liquidity problems.  As MFIs struggle to find affordable, available sources of funds, merging pools assets and increases MFI attractiveness to capital providers.  Consolidation would also likely result in economies of scale and thereby reduce operating expenses.  One interviewee reported a nearly two-thirds reduction in cumulative overhead costs following an MFI merger in Latin America. 

Given the saturation levels of many microfinance markets, industry consolidation is likely.  It stands to reason that the evolution of consolidation will follow a similar trajectory to the one taken by traditional banking.  First waves of consolidation will likely occur within MFI networks, in a particular province or state.  Second waves of consolidation will likely be within regions, across countries that share common currencies and compatible regulatory frameworks.  The third and increasingly sophisticated form of consolidation will be across national borders, again likely beginning with MFIs within a single network.22  

Recognizing these three phases of consolidation early and positioning to benefit from industry evolution will be a key success factor for all MFIs, but mid-sized MFIs in particular.  During the downturn, many mid-sized MFIs will find they are not quite strong enough to absorb economic shocks like their larger counterparts, and not quite lean enough to attract acquisition interest like their smaller, niche counterparts.  Most of the thinning in the microfinance sector will occur amongst mid-sized players with weaknesses in their operational and financial foundations.  These weaknesses, which were previously concealed in the good times of rapid growth, will be exposed by the crisis and in some cases cause institutional failure. 

To begin assessing the opportunities and risks associated with consolidation, microfinance institutions and networks might begin by:

• Mapping the MFI’s market niche (products offered, customers served) within the context of other MFIs in the network and/or market
• Quantifying a valuation of the MFI  
• Identifying the value proposition, strengths and weaknesses of the MFI
• Identifying potential synergies from consolidation
• Preparing for exploratory conversations

Implications for action- Capital providers

Public and private capital providers can each take action in the coming months that supports the microfinance sector and also furthers financial objectives.  For public investors, there are three recommended actions, and for private investors, one potential opportunity to be explored. 

1.    Go where others fear to tread

It is now more critical than ever for multilateral and bilateral development financial institutions to take higher-risk positions in order to encourage private capital flows into the sector.  Instead of providing financing to the larger, top-tier MFIs who can likely still attract private sector investment interest, development finance institutions should look to support second- and third-tier MFIs.  In recent years, some sector analysts concluded that development institutions were at risk of ‘crowding out’ private investors by investing in larger, more well-established MFIs, often at below-market price points.23 If IFIs were repelling private investors by their actions before, they must now solicit private investors’ interest by leaving lower-risk investment opportunities open, taking first loss positions in structured investments, and seeking to support the capital needs of the relatively under-served second- and third-tier MFIs.

2.    Assist as well as invest

Next, public investors should increase capacity-building services provided alongside financial infusions, and develop best practice guides for broader circulation.  Institutions and networks interviewed indicated an appetite for strategic and operational support during the downturn.   Key areas of need include training in market risk analysis, enhanced credit risk management techniques, and support in strengthening back office informational and financial systems. 

3.    Be the lender of last resort…in local currency

Lastly, public investors should continue to convene shareholders from the private sector to fund emergency liquidity and credit enhancement facilities of the sort that the Inter-American Development Bank, the World Bank, IFC, and the German development bank KfW have launched.   Unlike large banks, MFIs cannot typically obtain government-backed loans as bridge financing during difficult economic times, and so these facilities serve a critical need as lenders of last resort.   As Omtrix, fund manager for the IADB’s emergency facility, explains, these facilities are valuable not just in that they provide additional liquidity, but in how they provide that liquidity.  The more local currency funds that can be created, the less unhedged currency exposure will be inflicted upon MFIs.  

For private investors, it is still too early to say definitively what the performance of debt funds will be in 2009.  In a global downturn characterized by depreciating currencies, once marked-to-market, interest rates on loan funds may effectively be much higher to the borrowing MFI and as a result, default rates may rise and decrease overall returns.24 The outcome remains to be seen as MFIs turn increasingly to liquidity from their loan portfolios to service maturing debt obligations.  For equity investors, the financial crisis may offer opportunities. 

4.    Explore opportunities in equity

As discussed above, equity is a thin slice of the overall MFI liability structure, but it had recently begun to grow rapidly.  There were 24 equity funds by the end of 2008 totaling US$1.5bn under management.25 Since the deepening of the financial crisis, however, investor enthusiasm for microfinance equity deals appears to have become more subdued.   Perhaps it should not be.  MFIs are hungry for capital and in a climate of uncertainty, will likely offer equity stakes at lower prices.  Furthermore, given the general lack of liquidity in the market, MFIs may try to raise more equity finance than is strictly needed out of a desire to build a buffer against repayment volatility.  As a result, equity investors may see more, as well as cheaper, deals available.  Before successful exits are complete, it is difficult to predict the performance of these deals.  However, there are reasons for optimism. Sector fundamentals are strong.  Average asset size of microfinance banks grew by roughly 40% last year, and asset quality remains high with portfolio-at-risk ratios at less than 2% as of February 2009.26 The backbone of the sector is the low-income borrowers and they have been proven to rebound more quickly from financial downturns than commercial bank borrowers.27   Finally, returns on equity are attractive, as illustrated by a median ROE of about 14% in 2007.28 For all of these reasons, it remains worthwhile to explore equity investments in microfinance.

Conclusion

It is true that the global recession poses risks to the microfinance sector.  However the flip side of risk is opportunity.  The crisis can turn into a positive catharsis for those in the microfinance sector that can react nimbly to the seemingly unpredictable global economic environment. By anticipating and proactively responding to the conditions of the financial crisis, MFI managers and capital providers can, to a great extent, manage towards a positive outcome. 

More information